ITEM 1. BUSINESS.
American Health Properties, Inc. (the "Company," which term refers to the Company and its subsidiaries unless the context otherwise requires) is a self-administered real estate investment trust ("REIT") that commenced operations in 1987. The Company has investments in health care facilities that are operated by qualified third party health care providers, as well as medical office/clinic facilities.
The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. Attribution of the components of the Company's capital structure to its Core Group and Psychiatric Group for financial accounting and reporting purposes does not affect the legal title to assets or responsibility for liabilities of the Company, and each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to the risks associated with an investment in the Company and all of its businesses, assets and liabilities.
The Company's principal executive office is located at 6400 South Fiddler's Green Circle, Suite 1800, Englewood, Colorado 80111, and its telephone number at such address is (303) 796-9793.
THE CORE GROUP
The Core Group's portfolio of investments at December 31, 1998 consisted of 13 acute care hospitals, three rehabilitation hospitals, seven assisted living facilities (three of which are under construction), one mortgage loan secured by a long-term acute care hospital, one long-term acute care hospital, 16 skilled nursing facilities (one of which is under construction), 16 medical office/clinic facilities and three Alzheimer's care facilities (one of which is under construction). As of December 31, 1998, the net book value of the Core Group's total assets was $747 million. Of the Core Group's real estate assets at that date, 54% in net book value represented the acute care segment, 24% represented the medical office/clinic facilities, 12% represented the skilled nursing segment, 4% represented the assisted living segment, 4% represented the rehabilitation segment, 1% represented the Alzheimer's care segment and 1% represented the long-term acute care segment. As of December 31, 1998, 99% of the Core Group's real estate assets were held in fee and 1% was held as a mortgage loan.
The Core Group's facilities are diversified geographically across 21 states, are distributed among large and small population centers, and are operated by 13 experienced management companies. These operators include the following companies or their subsidiaries: Tenet Healthcare Corporation ("Tenet"), Columbia/HCA Healthcare Corporation, Covenant Care, Inc., Paracelsus Healthcare Corporation, HealthSouth Corporation, Community Health Systems, Inc., PhyCor, Inc., Balanced Care Corporation, Emeritus Corporation, Pine Haven Health Care II, Inc., Shannon Health System, RainTree Healthcare Corporation and SCCI Health Services Corporation. Facilities operated by Tenet represented 42% of the Core Group's total revenues for the year ended December 31, 1998.
Approximately 60% of the Core Group's property revenues for the year ended December 31, 1998 were secured by corporate guarantees of these operating companies or their subsidiaries. Also, as of December 31, 1998, letters of credit from commercial banks and cash deposits aggregating $17.2 million were available to the Core Group as security for lease financings. Leases for 19 of the Core Group's facilities, representing 51% of the Core Group's property revenues for the year ended December 31, 1998, contain cross-default provisions.
THE CORE GROUP FACILITIES
The Company's 62 Core Group facilities as of March 15, 1999, consisted of 13 acute care hospitals (the "Acute Care Hospitals"), three rehabilitation hospitals (the "Rehabilitation Hospitals"), seven assisted living facilities (three of which are under construction) (the "Assisted Living Facilities"), one mortgage loan secured by a long-term acute care hospital, one long-term acute care hospital (the "Long-Term Acute Care Hospital"), 16 skilled nursing facilities (one of which is under construction) (the "Skilled Nursing Facilities"), 17 medical office/clinic facilities (one of which is under construction) (the "Medical Office/ Clinic Facilities") and four Alzheimer's care facilities (two of which are under construction) (the "Alzheimer's Care Facilities" and together, the "Core Group Facilities"). Except for the long-term acute care hospital securing a mortgage loan, all of the Core Group Facilities are owned by the Company.
Acute Care Hospitals. The Acute Care Hospitals provide a wide range of services, which may include fully-equipped operating and recovery rooms, obstetrics, radiology, intensive care, open-heart surgery and coronary care, neurosurgery, neonatal intensive care, magnetic resonance imaging, nursing units, oncology, clinical laboratories, respiratory therapy, physical therapy, nuclear medicine, rehabilitation services and outpatient services.
Rehabilitation Hospitals. The Rehabilitation Hospitals provide acute rehabilitation care on a multidisciplinary, physician-directed basis to severely disabled patients. In addition to general medical rehabilitation programs, the Rehabilitation Hospitals offer a number of specialty programs, including pulmonary, ventilator, neurobehavioral, brain injury and pain programs. Each of the Rehabilitation Hospitals is operated pursuant to a joint venture between a publicly-held, national rehabilitation hospital operator and a local health care provider.
Assisted Living Facilities. The Assisted Living Facilities provide a special combination of housing, supportive services, personalized assistance and health care services designed to respond to the individual needs of the elderly and other persons who require help with activities of daily living. These services are available 24 hours a day to meet both scheduled and unscheduled needs in a way that promotes maximum dignity and independence for each resident.
Long-Term Acute Care Hospitals. The Long-Term Acute Care Hospitals provide care for patients with complex medical conditions that require more intensive care, monitoring, or emergency back-up than that available in most skilled nursing-based subacute programs. Most Long-Term Acute Care Hospital patients have severe chronic health problems and are medically unstable or at risk of medical instability. These patients have historically been treated in general acute care hospitals. The most common cases treated in this setting include high acuity ventilator-dependent patients and patients with multiple system failures related to cancer, spinal cord injuries or head injuries.
Skilled Nursing Facilities. The Skilled Nursing Facilities are skilled nursing centers that provide a broad range of health care services, including skilled nursing care, subacute care, rehabilitation therapy and other specialized services to the elderly and to other patients with medically complex needs who can be cared for outside of the acute care hospital environment and generally cannot be efficiently and effectively cared for at home.
Medical Office/Clinic Facilities. The Medical Office/Clinic Facilities include both single-tenant clinic facilities from which large medical practice groups provide a full range of services to their patients to multi-tenant medical office buildings which provide strategically located office space to physicians forming part of integrated health care delivery systems.
Alzheimer's Care Facilities. The Alzheimer's Care Facilities were developed in consultation with leading medical experts in the treatment of Alzheimer's disease and dementia, and have a strong health care orientation rather than the more customary residential care orientation.
The following is a listing of the Core Group portfolio of investments as of March 15, 1999.
CORE GROUP FACILITIES
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(1) Reflects gross investment or total investment commitment.
(2) Reflects contract rate of annual base rent or interest received or estimated to be received upon completion of construction or investment. For multi-tenant medical office/clinic facilities, annual base rent reflects the sum of the contract rate of base rent for individual tenants of each respective facility as of March 15, 1999.
(3) The leases and mortgages generally provide the lessees with renewal options to extend the term of the leases or mortgages beyond the primary term.
(4) Kendall Regional Medical Center (Kendall) is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at fair market value. See the Notes to the Consolidated Financial Statements, Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations, the Notes to the Core Group Combined Financial Statements and Management's Discussion and Analysis of Core Group Combined Financial Condition and Results of Operations in this Annual Report on Form 10-K for additional information.
(5) Currently under construction.
(6) Investment held in the form of a mortgage rather than owned by the Company.
(7) Casa Blanca Clinic represents four separate facilities leased together under a single master-lease. Fannin Medical Buildings represent two separate facilities master-leased to affiliated tenants under separate leases, one of which expires in 2004 and the other in 2006. Emerson Medical Office Building/Surgery Center represents two separate facilities, one of which is master-leased and expires in 2013 and the other leased to multiple tenants with various lease terms.
(8) Multi-tenant medical office/clinic facility with various lease terms.
(9) Property manager.
(10) Excludes multi-tenant medical office/clinic facilities.
See the Notes to the Consolidated Financial Statements, the Notes to the Core Group Combined Financial Statements and Schedule III -- Real Estate and Accumulated Depreciation included in this Annual Report on Form 10-K for additional information regarding the Core Group Facilities and for the carrying value and accumulated depreciation of the Core Group Facilities.
THE PSYCHIATRIC GROUP
The Psychiatric Group's portfolio of psychiatric hospital investments consists of two psychiatric hospitals owned by the Company (one of which has been closed) (the "Psychiatric Hospitals"). As of December 31,
1998, the net book value of the Psychiatric Group total assets was $7 million. All of the Psychiatric Group's real estate assets at that date were held in fee.
The Psychiatric Hospitals provide a wide range of inpatient and outpatient care for children, adolescents and adults, including specialized care relating to eating disorders, substance abuse and psychiatric illness. Fundamental changes in the psychiatric industry in recent years have reduced the operating cash flow at the Psychiatric Hospitals. These changes have had, and may continue to have, an adverse effect on the results of operations of the one remaining Psychiatric Hospital operator and borrower. As a result, the one remaining Psychiatric Hospital operator has had, and may continue to have, difficulty meeting its payment obligations to the Psychiatric Group. See "Management's Discussion and Analysis of Psychiatric Group Combined Financial Condition and Results of Operations -- Operating Results -- Analysis of Psychiatric Group" included elsewhere herein.
The following is a listing of the Psychiatric Group portfolio of investments as of March 15, 1999.
PSYCHIATRIC GROUP HOSPITALS
- - --------------- (1) Reflects gross investment less write-downs.
(2) Reflects contract rate of annual base rent.
(3) The Northpointe property has been vacant since mid-1997 and the Company incurs ongoing costs for maintenance and security of the property while it continues to seek alternate uses or a buyer for the property. See the Notes to the Consolidated Financial Statements, Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations, the Notes to the Psychiatric Group Combined Financial Statements, and Management's Discussion and Analysis of Psychiatric Group Combined Financial Condition and Results of Operations in this Annual Report on Form 10-K for additional information.
(4) Actual rent received for the year ended December 31, 1998 for Northpointe and Sunrise Regional Medical Center was $0 and $855,000, respectively.
(5) Health Systems America, Inc. is the operator and Sunrise Regional Medical Center, Ltd. is the lessee of Sunrise Regional Medical Center.
(6) The lease provides the lessee with renewal options to extend the term of the lease beyond the primary term.
See the Notes to the Consolidated Financial Statements, the Notes to the Psychiatric Group Combined Financial Statements and Schedule III -- Real Estate and Accumulated Depreciation included in this Annual Report on Form 10-K for additional information regarding the leased Psychiatric Hospitals and the mortgage loans and for the carrying value and accumulated depreciation of the Psychiatric Hospitals.
LEASES AND MORTGAGE LOANS
As of March 15, 1999, the Company owned 13 Acute Care Hospitals, two Psychiatric Hospitals, three Rehabilitation Hospitals, seven Assisted Living Facilities (three of which are under construction), one of the Long-Term Acute Care Hospitals, 16 Skilled Nursing Facilities, (one of which is under construction) and four Alzheimer's Care Facilities (two of which are under construction), which are collectively referred to herein as the "Leased Properties" or individually as a "Leased Property". The Company also owns
17 Medical Office/Clinic Facilities (one of which is under construction) which are collectively referred to herein as the "Leased MOB Properties".
The leases for the Leased Properties provide for base rental rates that generally range from 8.5% to 13.6% per annum of the acquisition price less write-downs of the related Leased Property. Rental rates vary by lease, taking into consideration many factors, including, but not limited to, credit of the lessee, operating performance of the Leased Property, interest rates, and location, type and physical condition of the Leased Property. The leases provide for additional rents that are generally based upon a percentage of increased revenues over specified base period revenues of the related Leased Properties.
The obligations under the leases are generally guaranteed by the parent corporation of the lessee, if the lessee is a subsidiary, or have some other form of credit enhancement such as a letter of credit or a security deposit. Certain of the Company's leases are with subsidiaries of the operators described above and are non-recourse to such operators. Approximately 60% of the Company's property revenues for the year ended December 31, 1998 were secured by corporate guarantees. Also, as of December 31, 1998, letters of credit from commercial banks and cash deposits aggregating $17.2 million were available to the Company as security for lease and construction development obligations.
The leases of single-tenant facilities are on a "triple net" basis, and the lessee is responsible thereunder for all additional charges, including every fine, penalty, interest and cost that may be levied for non-payment or late payment thereof, for taxes, assessments, levies, fees, water and sewer rents and charges, all governmental charges with respect to the Leased Property and all utility and other charges incurred in the operation of the Leased Property. Each such lessee is required, at its expense, to maintain the Leased Property in good order and repair. The Company is not required to repair, rebuild or maintain these Leased Properties.
Leases of office or other space within the Core Group's Leased MOB Properties vary from gross leases (where landlord is responsible for repairs, maintenance, insurance and taxes) to triple net leases (where tenant pays some or all such expenses). Generally, the market in which a multi-tenant medical office building is located will determine whether office space is leased on a net or gross basis. Leases to single-tenant Leased MOB Properties are usually on a net or triple net basis.
Core Group Facilities
Acute Care Hospitals. The Acute Care Hospital leases provide for a fixed term of five to 17 years and one or more renewal options of from five to ten years each. In addition to monthly base rent, all of the Acute Care Hospital leases provide for the quarterly payment of additional rent in an amount equal to (i) a specified percentage of the amount by which the gross revenues (as defined) attributable to the Leased Property for the year exceeded the gross revenues derived from such Leased Property during a specified base year ("Excess Gross Revenues") up to a designated dollar amount (the "Transition Amount"). Should the Transition Amount be reached in any year, additional rent is equal to a reduced percentage of the Excess Gross Revenues for the remainder of such year.
Pursuant to the terms of the Acute Care Hospital leases, the Company has the right to approve capital expenditures (only in excess of $2 million for certain leases), the option to fund certain capital expenditures under some of the leases and, in certain situations, is obligated to fund approved capital expenditures on terms comparable to the original investment. The base and additional rent provisions of leases are amended when such capital expenditures are funded to reflect the Company's increased investment.
Six of the Acute Care Hospitals are operated by subsidiaries of American Medical International, Inc. ("AMI"), a subsidiary of Tenet, under long-term leases with the Company, which comprised 42% of the Core Group's total revenues for the year ended December 31, 1998. AMI has guaranteed certain obligations of its subsidiaries under such leases and each such lease is cross-defaulted to the other AMI leases. Five of the AMI leases grant to AMI the option, exercisable on not less than six months nor more than 24 months notice, to purchase the Leased Property upon the expiration of any term of the lease at the Fair Market Value of the Leased Property at the expiration of said term. For purposes of the preceding sentence, "Fair Market Value" means the price that a willing buyer not compelled to buy would pay to a willing seller not compelled to sell for
such property at the applicable expiration less the portion of such price attributable to capital additions paid for by AMI. The determination of such price will take into account (i) that the applicable lease is assumed not to be in effect on the Leased Property and (ii) that the seller of such Leased Property must pay for title insurance and closing costs.
One of the Acute Care Hospitals, Kendall, is leased to a subsidiary of Columbia. Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at the fair market value of the Leased Property. See the Notes to the Consolidated Financial Statements, Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations, the Notes to the Core Group Combined Financial Statements and Management's Discussion and Analysis of Core Group Combined Financial Condition and Results of Operations in this Annual Report on Form 10-K for additional information.
Three of the leases generally provide the lessee with an option to purchase the property at the end of the term of the lease at the greater of the fair market value (or some percentage thereof) or total investment cost (as defined). One of the leases provides the lessee with a purchase option, on or after the fifth anniversary of the lease, at the greater of fair market value or total investment cost (as defined). One of the leases provides the lessee with a purchase option during the term of the lease at a predetermined purchase price designed to provide the Company with a favorable total return on its investment. In addition, this lease provides the lessee with an option to purchase the property at the end of the term of the lease at the greater of 90% of the fair market value of the Leased Property or 125% of the total investment cost (as defined).
Rehabilitation Hospitals. The Rehabilitation Hospital leases provide for an initial term of ten years and three renewal periods of five years each, except in the case of the HealthSouth MountainView Rehabilitation Hospital lease, which provides for two renewal periods of ten years each and a third renewal period of up to fifteen years. In addition to monthly base rent, the Rehabilitation Hospital leases provide for the quarterly payment of additional rent in an amount equal to a specified percentage of Excess Gross Revenues. The Rehabilitation Hospital leases each grant to the operator the option to purchase the Rehabilitation Hospital upon expiration of any term of the lease at the greater of the fair market value of, or the Company's cost basis in, the Rehabilitation Hospital at the expiration of said term.
Assisted Living Facilities. Four of the Assisted Living Facilities are operated by an affiliate of Emeritus Corporation ("Emeritus") and all leases for such facilities are cross-defaulted. These Assisted Living Facility leases provide for a ten year initial term with six renewal periods of five years each. These four Emeritus Assisted Living Facility leases provide for monthly base rent plus additional rent payable quarterly in an amount equal to the sum of (i) the additional rent for the immediately preceding year and (ii) an amount equal to a specified percentage of the sum of base rent and additional rent payable for the immediately preceding year. These leases provide the tenant with the option to purchase the property at the end of the fixed term or at the end of any extended term at the greater of (i) fair market value minus the tenant's share of the appreciation amount (as defined) less the fair market value of any improvements funded by the tenant or (ii) the Company's total investment (as defined).
The Company has also entered into a conditional commitment to develop up to five assisted living facilities, each of which will be managed and operated by a subsidiary of Balanced Care Corporation ("Balanced Care"). An entity independent of both Balanced Care and the Company will lease each such facility for a term commencing upon completion of construction and ending ten years thereafter. Each such lease will also provide three five-year renewal terms at the option of the tenant. The Balanced Care leases set forth monthly base rent payments that escalate each year of the lease based upon an adjustment factor related to inflation. Balanced Care has an option to acquire the equity interests of the tenant, the leasehold interest and other assets of the tenant and a right of first offer to purchase the properties that are the subject of a lease. In addition, the tenant under the Balanced Care lease has the option to purchase all of the leased properties in a pool in 2008 with such option extended by five years if the option for extension of the term of the leases is exercised by tenant. Balanced Care has committed to provide working capital support for each tenant, including support for rental obligations owed to the Company. Each lease entered into under the Company's development commitment for these facilities will be cross-defaulted to the other executed leases. Three
facilities have commenced construction. Two of these facilities will be completed during the second quarter of 1999 while the third facility is anticipated to be completed during the third quarter of 1999.
Long-Term Acute Care Hospitals. The Long-Term Acute Care Hospital that is owned by the Company is leased to an affiliate of SCCI Health Services Corporation ("SCCI") pursuant to a ten-year lease. This lease provides for monthly payments of base rent along with quarterly payments of additional rent in an amount equal to a specified percentage of Excess Gross Revenues. The participation rate in Excess Gross Revenues is equal to a reduced percentage upon reaching a predetermined rate of return. This lease provides the tenant with three renewal terms of ten years each and the option to purchase the property at the end of the fixed term or at the end of any extended term at the greater of (i) fair market value or (ii) the Company's total investment (as defined). The lease has been guaranteed by SCCI.
The Company holds a mortgage on one of the Long-Term Acute Care Hospitals. The mortgage provides for an initial term of ten years and two renewal terms of ten years each. An affiliate of SCCI owns and operates this Long-Term Acute Care Hospital. SCCI has guaranteed the obligations under the mortgage and has pledged to the Company the stock of the affiliate owning the Long-Term Acute Care Hospital in order to secure its guaranty. The mortgage sets forth monthly payments of principal plus base interest as well as quarterly payments of additional interest in an amount equal to (i) net revenues (as defined) for the current year, minus (ii) net revenues for the base year (as defined), multiplied by (iii) a specified percentage.
Skilled Nursing Facilities. Six of the Skilled Nursing Facility leases establishes an initial term of ten years and an option for three renewal terms of ten years each. Each of the other ten leases establishes an initial term of fifteen years and an option for three renewal terms of ten years each. Four of the Skilled Nursing Facilities are operated by an affiliate of RainTree Healthcare Corporation (formerly Unison Healthcare Group, Inc.) ("RainTree") and all of the leases for the RainTree facilities are cross-defaulted. Additionally, the obligations under each RainTree lease are guaranteed by RainTree and an affiliate of RainTree. The RainTree leases provide for monthly base rent, which is automatically increased by a specified percentage each year. Each of the RainTree Skilled Nursing Facility leases provides the tenant with an option to purchase the property at the end of the fixed term or the end of any extended term at the greater of fair market value or the total investment cost (as defined), provided that the option to purchase the property is simultaneously exercised on each of the Skilled Nursing Facilities operated by the tenant. The RainTree leases also provide the tenant with a right of first refusal to purchase the property on the same terms and conditions as received by and acceptable to the Company.
Twelve Skilled Nursing Facilities are operated by an affiliate of Covenant Care, Inc. ("Covenant Care"). Certain of the leases for these facilities are cross-defaulted and the obligations under each Covenant Care lease is guaranteed by Covenant Care. Two of the Covenant Care leases set forth monthly base rent payments plus quarterly additional rent payments in an amount equal to (i) net revenues (as defined) for the current year, minus (ii) net revenues for the base year (as defined), multiplied by (iii) a specified percentage. Ten of the Covenant Care leases provide for monthly base rent plus additional rent payable quarterly in an amount equal to the sum of (i) additional rent for the immediately preceding year and (ii) an amount equal to a specified percentage of the sum of base rent and additional rent payable for the immediately preceding year. The Covenant Care leases provide the tenant with a right of first refusal to purchase the properties at a purchase price equal to the greater of fair market value or the total investment cost (as defined) for unsolicited offers to sell by the Company or equal to the greater of the total investment cost or the purchase price contained in any offer to purchase received by and acceptable to the Company.
Medical Office/Clinic Facilities. Ten of the medical office/clinic facilities are master leased to Columbia/HCA Healthcare Corporation, Casa Blanca Clinic, a physician practice group managed by PhyCor, Inc., Wellpoint Health Networks, Inc., Murfreesboro Medical Clinic, Mercy Medical Center, Inc. and Medical Partners Surgery Center, Ltd. for remaining terms ranging from six to fifteen years. Six of the medical office/clinic facilities are leased to multiple tenants for remaining terms ranging from one to ten years. One of the medical office/clinic facilities is master-leased for a five-year remaining term to a partnership consisting of 22 physicians who are the primary tenants of the building.
Alzheimer's Care Facilities. The Alzheimer's Care Facility leases provide for a ten-year initial term with three renewal periods of ten years each. The Alzheimer's Care Facilities are leased to affiliates of Pine Haven Health Care II, Inc. and provide for monthly base rent plus additional rent payable quarterly in an amount equal to the sum of (i) additional rent for the immediately preceding year and (ii) an amount equal to a specified percentage of the sum of base rent and additional rent payable for the immediately preceding year. The leases provide the tenant with the option to purchase the property at the end of the fixed term or at the end of any extended term at a purchase price equal to the greater of the fair market value or total investment cost (as defined). The Company has also entered into a commitment to develop up to seven additional Alzheimer's care facilities to be operated and leased by Pine Haven Health Care II, Inc. on substantially similar terms.
Psychiatric Group Facilities
Psychiatric Hospitals. The lease for one of the owned Psychiatric Hospitals provides for an initial term expiring in 2003 with three renewal periods, one for five years followed by two for ten years each. The other Psychiatric Hospital has been vacant since mid-1997.
The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in the periodic restructuring of psychiatric operator payment obligations, the closing of one psychiatric hospital and significant impairment losses on psychiatric investments, including an $11 million charge in 1997 and a $5.6 million charge in 1998. At December 31, 1998, the aggregate carrying value of the Company's psychiatric properties was $5,131,000. The Northpointe property has been vacant since mid-1997 and has a carrying value of $1,300,000. The Company incurs ongoing costs for maintenance and security of the property while it continues to seek alternate uses or a buyer for the property. The operator of the Rock Creek Center (RCC) experienced continuing financial and operational difficulties over the past several years, and at the end of 1998, the operator was in default on its obligations to the Company. As a result, the carrying value of the RCC property was written down to $1,200,000 and the Company's net investment in related notes and various other obligations owed to it by the operator of RCC were totally written off. Subsequent to year-end in February 1999, the Company sold its total RCC investment for a cash price of $2.5 million. At December 31, 1998, the Sunrise Regional Medical Center (Sunrise) property had a carrying value of $2,631,000. In September 1998, a new operator assumed all operational responsibility for the hospital and entered into a new five-year lease with effective monthly rent of $60,000. Although the new operator has fulfilled its obligations to the Company under the lease so far, the new operator has experienced cash flow difficulties primarily as a result of delays in obtaining Baker Act certification. As a result, the Company provided the operator with a $200,000 working capital loan at the end of 1998, and subsequent to year-end, the operator requested $700,000 of additional working capital loans. Although this request is still being evaluated, the Company likely will provide the additional loans. The Company cannot be assured that the operator will be successful and, if it were to cease operations, an impairment charge to reduce the carrying value of the Sunrise property and any related outstanding working capital loans would be likely. The Company will continue to encourage the operator to pursue financing alternatives that might enable it to acquire the property and repay its borrowings from the Company.
Dividends on the Company's Psychiatric Group Depositary Shares are determined each quarter based upon the operating results of the Company's Psychiatric Group. It continues to be the policy of the Board to maintain a dividend payout ratio for each quarter in excess of 90 percent of the Psychiatric Group's funds from operations for the related quarter, when possible. With the disposition of the RCC investment in February 1999, the Sunrise investment is currently the sole income-producing property of the Company's Psychiatric Group and the operator of Sunrise is experiencing cash flow difficulties. Therefore, commencing in the second quarter of 1999, the Psychiatric Group's funds from operations may not be sufficient to permit the payment of a dividend on the Psychiatric Group Depositary Shares.
The Company intends to periodically evaluate the financial position of the Psychiatric Group, including an assessment of the potential cash requirements of the Psychiatric Group and the appropriate use of the proceeds from the February 1999 sale of the RCC investment. Initially, proceeds from the RCC disposition, net of closing costs and applicable reserves, will be retained by the Psychiatric Group to defray its ongoing
costs, including the potential long-term costs of carrying the two remaining Psychiatric Group properties. The Psychiatric Group may continue to retain such proceeds or, alternatively, may distribute a portion of such net proceeds to holders of Psychiatric Group Depositary Shares, in cash or Core Group Common Stock, either by dividend or in connection with redemption of the Psychiatric Group Depositary Shares. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may elect to redeem the outstanding Psychiatric Group Depositary Shares in cash or in exchange for shares of Core Group Common Stock. Under the terms of the Certificate of Designations for the Psychiatric Group Preferred Stock and the Deposit Agreement providing for issuance of Depositary Receipts (Psychiatric Group Depositary Shares) each representing one-tenth of one share of the Psychiatric Group Preferred Stock, the Company has the right to redeem all outstanding Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, for cash (or in exchange for newly issued shares of Core Group Common Stock) at a premium generally ranging from 5% to 15% over the value of the Psychiatric Group Depositary Shares. Since an exchange or redemption of the Psychiatric Group Depositary Shares may be at a premium to the then current market price of the Psychiatric Group Depositary Shares, and since the Board could determine to effect such an exchange or redemption at a time when either or both the Core Group Common Stock and the Psychiatric Group Depositary Shares may be considered to be overvalued or undervalued, the exchange or redemption could be disadvantageous to the holders of the Core Group Common Stock or the Psychiatric Group Depositary Shares.
For a fuller discussion of the Company's Psychiatric Group investments and certain issues facing the operators of the Company's Psychiatric Group Facilities, see "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations -- Operating Results -- Future Operating Results" and "Management's Discussion and Analysis of Psychiatric Group Combined Financial Condition and Results of Operations -- Operating Results -- Future Operating Results" included elsewhere herein.
COMPETITION
The Company competes with health care providers, real estate partnerships, other real estate investment trusts and other investors, including insurance companies and banks, generally in the acquisition, leasing and financing of health care facilities.
Management of the Company believes that the single-tenant facilities in which it has invested (the "Single-Tenant Facilities") provide high quality health care services in their respective markets. The operators of the Single-Tenant Facilities compete on a local and regional basis with other operators of comparable facilities. They compete with independent operators as well as managers of multiple facilities, some of which are substantially larger and have greater resources than the operators of the Single-Tenant Facilities. Some of these competing facilities are operated for profit while others are owned by governmental agencies or tax-exempt, not-for-profit organizations. The Company believes that the Single-Tenant Facilities compete favorably with other health care facilities based upon many factors, including the services and specialties offered, quality of management, ease of access, reputation and the ability to attract competent physicians and maintain strong physician relationships.
Management of the Company likewise believes that the multi-tenant medical office/clinic facilities in which it has invested (the "Multi-Tenant Facilities" and, together with the Single-Tenant Facilities, the "Facilities") are well-positioned in their markets. These Multi-Tenant Facilities compete with other medical office buildings for tenants based upon the amenities they offer and their proximity to acute care hospitals and other health care facilities.
ENVIRONMENTAL MATTERS
Under various federal, state and local laws and regulations, an owner of real estate is liable for the costs of removal or remediation of certain hazardous or toxic substances on such property. Such laws often impose such liability without regard to whether the owner knew of, or was responsible for, the presence of such hazardous or toxic substances. The costs of remediation or removal of such substances may be substantial, and
the presence of such substances, or the failure to promptly remediate such substances, may adversely affect the owner's ability to sell such real estate or to borrow using such real estate as collateral. In connection with its ownership and operation of the Facilities, the Company may be potentially liable for such costs.
The Company conducts Phase I environmental assessments on properties it acquires, which assessments are intended to discover information regarding, and to evaluate the environmental condition of, the surveyed properties and surrounding properties. The Phase I assessments typically include a historical review, a public records review, a preliminary investigation of the site and surrounding properties, screening for the presence of asbestos, polychlorinated biphenyls and underground storage tanks and the preparation and issuance of a written report, but do not include soil sampling or subsurface investigations. In each case where Phase I assessments resulted in specific recommendations for remedial actions, the Company's management has taken action with respect to the issues raised.
The Phase I assessments obtained by the Company have not revealed any environmental liability that the Company believes would have a material adverse effect on the Company's business, assets or results of operations. Nevertheless, it is possible that these assessments do not reveal all environmental liabilities or that there are material environmental liabilities of which the Company is unaware. Moreover, no assurances can be given that (i) future laws, ordinances or regulations will not impose any material environmental liability or (ii) the current environmental condition of the Facilities will not be affected by tenants and occupants of the Facilities, by the condition of properties in the vicinity of the Facilities (such as the presence of underground storage tanks) or by third parties unrelated to the Company.
The Company believes that the Facilities are in compliance in all material respects with all federal, state and local ordinances and regulations regarding hazardous or toxic substances. The Company has not been notified by any governmental authority and is not otherwise aware of any material noncompliance, liability or claim relating to hazardous or toxic substances in connection with any of its present or former properties.
GOVERNMENT REGULATIONS AND PAYOR ARRANGEMENTS
Each of the Facilities is a health care related facility and the amount of additional rent or additional interest, if any, which is based on the lessee's or mortgagor's gross revenue, and the ability of the operators of the Facilities to meet their payment obligations to the Company, are in most cases subject to changes in the reimbursement policies of federal, state and local governments. In addition, the acquisition or construction of a health care facility is generally subject to state and local regulatory approval.
The operators and tenants of most of the Facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants are also subject to extensive federal, state and local government regulation relating to their operations, and the Company's facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third party payors or an operator's or tenant's failure to maintain its certification under the Medicare or Medicaid programs could adversely affect revenues to the Facilities.
In recent years, an increasing number of legislative proposals have been introduced or proposed in Congress and in some state legislatures that would effect major changes in the health care system, either nationally or at the state level. Among the proposals under consideration are cost controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses and the requirement that all businesses offer health insurance to their employees. In addition, Congress is considering various proposals relating to the Medicare and Medicaid programs, including a proposal to offer medical savings accounts in lieu of Medicare coverage (which has received Congressional approval for a pilot study) and a proposal to abandon the current Medicaid funding system in favor of federal block grants to states. The proposals adopted and under consideration by Congress are designed to reduce federal government spending
on the Medicare and Medicaid programs. Accordingly, these proposed legislative changes could adversely affect revenues to the Facilities.
On August 5, 1997, President Clinton signed into law the Balanced Budget Act of 1997 (the "Budget Act"), which reduces the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. The Budget Act contains reductions in payments for inpatient services, capital expenditures, graduate medical education, outpatient services, clinical laboratory services and physician services, and adopted a variety of changes to the Medicare and Medicaid programs, including (a) the adoption of the Medicare+Choice program, which expands Medicare beneficiaries' choices to include traditional Medicare fee-for-service, private fee-for-service, medical savings accounts, various managed care plans, and provider sponsored organizations, among others, (b) the reduction of reimbursement for various services to Medicare beneficiaries, (c) a freeze in hospital rates in 1998 and more limited annual increases in hospital rates for 1999 through 2002, (d) the adoption of a prospective pay system for skilled nursing facilities, home health agencies, hospital outpatient departments and rehabilitation hospitals, (e) the repeal of the Boren amendment in Medicaid so that states have the exclusive authority to determine provider rates, and (f) the reduction in Medicare disproportionate share payments to hospitals. The reductions on Medicare and Medicaid spending imposed by the Budget Act may have an adverse impact on the revenues of the Company's operators and the physicians who are tenants at the Company's medical office buildings. See "Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations -- Future Operating Results."
Prior to the Budget Act's repeal of the Boren amendment, state Medicaid programs were required to pay hospitals and nursing facilities based on rates that were reasonable and adequate to meet the costs that must be incurred by efficiently and economically operated facilities in order to provide services in conformity with federal and state standards and to assure that patients retain reasonable access to medical services. After passage of the Budget Act, states need only publish the methodology used to develop the proposed rates, along with a justification for the methodology, and allow public comment. As a result of this change, states may be able to reduce their Medicaid reimbursement levels more easily, and the Company's operators may therefore experience reduced Medicaid payments.
Health care operators are also subject to federal and state laws and regulations that govern financial and other arrangements between health care providers. These laws prohibit certain direct and indirect payments or fee-splitting arrangements between health care providers that are designed to induce or encourage the referral of patients to, or the recommendation of, a particular provider for medical products and services. The Budget Act strengthened these anti-fraud and abuse laws to provide for stiffer penalties for fraud and abuse violations.
Acute Care Hospitals. Acute care hospitals are subject to extensive federal, state and local legislation and regulation. Acute care hospitals undergo periodic inspections regarding standards of medical care, equipment and hygiene as a condition of licensure. In certain states the construction, acquisition or lease of an acute care hospital may be subject to certificate of need review. Various licenses and permits also are required for narcotics, laboratories, pharmacies, radioactive materials and certain equipment. Each facility eligible for accreditation is accredited by the Joint Commission on Accreditation of Health Care Organizations. Accreditation is generally required for participation in government-sponsored provider programs, such as Medicare and Medicaid.
Acute care hospitals are subject to and comply with various forms of utilization review. In addition, under the Medicare program, each state must have a Professional Review Organization to carry out a federally-mandated system of review of Medicare patient admission, treatment and discharge. Medical and surgical services and practices are extensively supervised by committees of staff doctors at each acute care hospital, and are reviewed by each acute care hospital's local governing board and quality-assurance personnel. New regulations governing the control of disposal of hazardous wastes may increase the costs of operating acute care facilities.
The lessees and mortgagors of the Acute Care Hospitals, receive payments for patient care from the federal Medicare program for elderly and disabled patients, Medicaid and other state programs for medically
indigent patients, private insurance carriers, employers, Blue Cross or Blue Shield plans, health maintenance organizations, preferred provider organizations and directly from patients.
Medicare payments for most inpatient hospital services provided by acute care general hospitals are made under a "prospective payment system" ("PPS") under which a hospital is paid a prospectively determined rate per discharge. The PPS payment rate includes reimbursement for capital related costs. These rates vary according to a patient classification system that is based on clinical, diagnostic and other factors. The Budget Act imposed a freeze in Medicare rates for hospital services in 1998 and more limited annual increases in such rates for 1999 through 2002. Acute care hospitals are reimbursed for cost reimbursable items at a tentative rate with final settlement determined after submission of annual cost reports and audits thereof by the Medicare fiscal intermediary. In general, payments made by Medicare are less than established charges for such services. Medicare payments may be delayed due to audits by Medicare fiscal intermediaries conducted under federal government regulations.
Medicaid payments for acute care hospitals will vary from state to state. These payments may be based on a percentage of reasonable cost, a fixed rate per discharge, a capitated payment, or other payment arrangements. If a state selects a cost-based reimbursement methodology, acute care hospitals are reimbursed at a tentative rate with final settlement determined after submission of annual cost reports and audits thereof by Medicaid. In general, payments made by Medicaid are less than established charges for such services. Additionally, Medicaid payments may be delayed due to state budget deficits and audits by Medicaid fiscal intermediaries conducted under federal government regulations.
Blue Cross and Blue Shield payments in different states and areas are based on cost, a per diem, or other negotiated rates and may also be subject to payment delay. Payments from health maintenance organizations and preferred provider organizations generally are negotiated, either at a discount from charges or on a per capita, risk-sharing basis with stop-loss provisions for high severity cases. In more developed markets such as California and Florida, the Company's hospitals are now entering into risk-sharing, or capitated, arrangements. These arrangements reimburse the hospital based on a fixed fee per participant in a managed care plan with the hospital assuming the costs of services provided, regardless of the level of utilization. If utilization is higher than anticipated and/or costs are not effectively controlled, such arrangements could produce low or negative operating margins.
Rehabilitation Hospitals. Rehabilitation hospitals are also subject to extensive federal, state and local legislation and regulation. Rehabilitation hospitals are subject to periodic inspections and licensure requirements and construction, acquisition or lease of such hospitals may be subject to certificate of need review. Medicare payments for inpatient rehabilitative services currently are based on reasonable operating cost, subject to a per discharge limitation. If a facility operates below the cost per discharge limitation, it will qualify for a bonus payment. If a facility operates above the cost per discharge limitation, it will be reimbursed solely to the extent of the limitation. The Budget Act altered the Medicare payment rules for rehabilitation hospitals effective October 1, 1997 to limit further reimbursable costs, reduce payment incentives for providers whose costs are below the discharge limitation, and reduce capital related payments. In addition, the Budget Act implemented a new payment system for rehabilitation services that will be phased in after October 1, 2000. Under the new system, payments to rehabilitation hospitals will be based on fixed rates per discharge that will vary according to the nature of the patient's condition. All Medicare inpatient and outpatient services currently are reimbursed at a tentative rate with final settlement determined after submission of annual cost reports and audits thereof by the Medicare fiscal intermediary. In general, payments made by Medicare are less than established charges for such services. Additionally, Medicare payments may be delayed due to audits by Medicare fiscal intermediaries under federal government regulations.
Assisted Living Facilities. Assisted living facilities are subject to state and local legislation and regulation. Assisted living facilities are not currently regulated by the federal government. Assisted living facilities are subject to licensure requirements, and are surveyed on a regular basis to determine whether such facilities are in compliance with such licensure requirements and with the requirements for participation in the Medicaid program in the states where assisted living facilities are eligible for Medicaid reimbursement. The operators of the Company's Assisted Living Facilities primarily target the private pay sector of the assisted
living services market, and generally do not target Medicaid patients for admission to their facilities. Private pay patients utilize private insurance sources for payment or use their income and savings to pay for care in assisted living facilities.
Long-Term Acute Care Facilities. The development and operation of long-term acute care hospitals ("LTACs") are subject to federal, state and local licensure and certification laws that regulate, among other things, the services provided, distribution of pharmaceuticals, equipment, staffing requirements, operating policies, fire prevention and compliance with building codes. LTACs are designated long stay, acute hospitals by the Health Care Financing Administration ("HCFA"). Medicare payments for LTAC services are based on reasonable operating costs, subject to a per discharge limitation. The Budget Act also altered the Medicare payment rules for LTACs to limit future reimbursable costs, reduce payment incentives for providers whose costs are below the discharge limitation, and reduce capital related payments. In order to qualify for exemption from the prospective payment system, LTACs are required to maintain an average length of stay of at least 25 days.
Skilled Nursing Facilities. Skilled nursing facilities are also subject to extensive federal, state and local legislation and regulation. Construction, acquisition or lease of skilled nursing facilities may also be subject to certificate of need review. Skilled nursing facilities are subject to licensure requirements, and are surveyed on a regular basis to determine whether such facilities are in compliance with the requirements for participation in the Medicare and Medicaid programs. Medicare provides coverage for beneficiaries who require skilled nursing and certain related medical services, such as physical, occupational and speech therapy, pharmaceuticals, medical supplies and ancillary, diagnostic and other necessary services of the type provided by skilled nursing facilities. Medicare benefits are not available for patients requiring intermediate and custodial levels of care. The Budget Act established a prospective payment system for skilled nursing facilities that goes into effect on July 1, 1998. During the first three years of the new system, the per diem rates for skilled nursing facilities (other than new facilities) will be based on a blend of facility-specific costs and federal costs. Thereafter, the per diem rates for skilled nursing services will be based solely on federal costs. Per diem rates for skilled nursing facilities first receiving Medicare payments on or after October 1, 1995 will be based solely on federal costs. The payments received under the new prospective payment system will cover all services for Medicare patients, including all ancillary services, such as respiratory therapy, physical therapy, occupational therapy, speech therapy and certain covered drugs. Capital costs will also be included in the prospective payment per diem rates. Although Medicaid programs vary from state to state, reimbursement rates for skilled nursing services are typically determined by the state from cost reports filed annually by each facility, on a prospective or retrospective basis. Under most state Medicaid programs, individual facilities are reimbursed on a prospective rate system, subject to retroactive adjustment. Under a prospective system, per diem rates are established based upon certain historical costs of providing services during the prior year, adjusted to reflect factors such as inflation and any additional services required to be performed. Providers must accept reimbursement from Medicaid as payment in full for the services rendered.
Alzheimer's Care Facilities. Alzheimer's care facilities are classified as long-term care facilities and are reimbursed under the same payment arrangements as long-term care facilities to the extent that the operator elects to participate in the Medicare and Medicaid programs.
Psychiatric Hospitals. In addition to the licensing, certificate of need and Medicare/Medicaid rules and regulations, there are a number of specific federal and state laws affecting psychiatric hospitals, such as the regulation of civil commitments of patients, admitting procedures, and disclosure of information regarding patients being treated for chemical dependency. Many states have adopted a "patient's bill of rights" which sets forth standards governing the treatment of patients of psychiatric hospitals, such as using the least restrictive treatment method, allowing patient access to telephone and mail, allowing a patient to see a lawyer, and requiring the patient to be treated with dignity. The lessee of the Sunrise Regional Medical Center receives payments for patient care from the federal Medicare program for elderly and disabled patients, private insurance carriers, employers, Blue Cross or Blue Shield plans, health maintenance organizations, preferred provider organizations and directly from patients.
EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company are as follows:
JOSEPH P. SULLIVAN -- Mr. Sullivan was elected President and Chief Executive Officer of the Company and a member of the Board of Directors effective February 11, 1993. Mr. Sullivan was elected Chairman of the Board of Directors in November 1996. Prior to that, Mr. Sullivan spent 20 years with Goldman, Sachs & Co. where he had overall investment banking responsibility for numerous companies in the health care field.
MICHAEL J. MCGEE -- Mr. McGee has been Senior Vice President and Chief Financial Officer of the Company since January 1996, has served as Treasurer of the Company since August 1995 and previously served as Controller of the Company from November 1989 to February 1998. Mr. McGee was a certified public accountant with Arthur Andersen LLP from 1977 to November 1989.
STEVEN A. ROSEMAN -- Mr. Roseman has been Senior Vice President, General Counsel and Secretary of the Company since July 1997. Prior to that Mr. Roseman had established his own legal practice, and from April 1995 to August 1996 he was Vice President Business Affairs Worldwide Pay Television for Paramount Pictures Corporation. From September 1983 to April 1995 he was with the law firm of Ervin, Cohen & Jessup, Beverly Hills, California and was a partner in that firm's tax and real estate department.
C. GREGORY SCHONERT -- Mr. Schonert has been Senior Vice President and Chief Development Officer of the Company since April 1988. Prior to that Mr. Schonert was Assistance Administrator of Marketing and Planning at St. Joseph's Hospital, Houston, Texas from February 1987. From September 1985 until February 1987, Mr. Schonert was a Manager in the Corporate Development Department of AMI.
Each executive officer is elected by the Board of Directors at its first meeting after each annual meeting of the shareholders and serves until such time as his successor is elected.
ITEM 2.
ITEM 2. PROPERTIES.
See "Item 1. Business" for a description of properties owned by the Company or subject to mortgages held by the Company.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not currently involved in any material litigation nor, to the Company's knowledge, is any litigation currently threatened against the Company or its properties, other than routine litigation arising in the ordinary course of business that, if determined adversely, would not have a material adverse effect on the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S VOTING STOCK AND RELATED STOCKHOLDER MATTERS.
The Common Stock of American Health Properties, Inc. is traded on The New York Stock Exchange ("NYSE") under the trading symbol "AHE." The Psychiatric Group Depositary Shares of American Health Properties, Inc. are traded on the Nasdaq National Market System ("Nasdaq") under the trading symbol "AHEPZ." The table below shows the reported high and low sales prices (i) for the Company's Common Stock as reported by the NYSE Composite Tape for the last two fiscal years and the cash dividends declared per share with respect to such periods, and (ii) for the Company's Psychiatric Group Depositary Shares as reported by Nasdaq for the last two fiscal years and the cash dividends declared per share with respect to such periods.
On July 24, 1998, a special dividend was paid to Psychiatric Group Depositary shareholders of record on July 17, 1998 in the form of the Company's Common Stock. Each holder of Psychiatric Group Depositary Shares received 0.4 of a share of Common Stock, valued at $10.37628, for each one Psychiatric Group Depositary Share.
As of March 12, 1999, the reported high and low sales prices (i) for the Company's Common Stock for 1999 were $21 15/16 and $17 7/16, respectively, and (ii) for the Company's Psychiatric Group Depositary Shares for 1999 were $2 3/4 and $1 1/32, respectively. As of March 12, 1999, there were approximately (i) 4,054 holders of record and 24,984,422 shares outstanding of the Company's Common Stock, and (ii) 2,733 holders of record and 2,083,931 shares outstanding of the Company's Psychiatric Group Depositary Shares.
In general, cash dividends on the Company's Common Stock and Psychiatric Group Stock are limited by the Company's unsecured revolving credit agreement to 95% of cash flow available for debt service, less interest expense, plus gains on asset dispositions and certain proceeds from the disposition of Psychiatric Group assets.
The Certificate of Designation for the Series B Preferred Stock prohibits the Company from redeeming or declaring a dividend on the Common Stock or the Psychiatric Group Depositary Shares unless all cumulative dividends with respect to the Series B Preferred Stock have been paid or funds have been set apart for the payment of such dividends.
The Company expects that quarterly dividends on the Common Stock and the Psychiatric Group Stock in the future will be based primarily upon the funds from operations attributable to the Core Group and the Psychiatric Group, respectively, after the payment of dividends on the Series B Preferred Stock. Specifically, the Company expects to maintain the Common Stock dividend payout ratio at less than 90% of annual funds from operations attributable to the Core Group and the Psychiatric Group Stock dividend payout ratio
(excluding distributions out of PG Excess Proceeds) at less than 95% of annual funds from operations attributable to the Psychiatric Group.
The payment of dividends on the Common Stock and the Psychiatric Group Stock will also be dependent in part upon the financial condition of the Company as a whole.
The Company expects the aggregate annual dividends paid on the Common Stock and the Psychiatric Group Stock to be at least sufficient to cause the Company to maintain its status as a REIT. In order to permit the Company to qualify as a REIT, the Company must distribute to stockholders at least 95% of its annual REIT taxable income (which essentially is its net ordinary income, excluding capital gains). Generally, as a result of non-cash items, primarily depreciation, cash dividends have exceeded and may continue to exceed the Company's REIT taxable income and to that extent represent a return of capital.
Dividends on the Common Stock and the Psychiatric Group Stock will be limited to the available dividend amount attributable to the Core Group and the Psychiatric Group, respectively. The available dividend amount is similar to the amount that would be legally available under Delaware law for the payment of dividends by the Core Group or the Psychiatric Group, as the case may be, if such Group were a separate Delaware corporation. There can be no assurance that there will be an available dividend amount with respect to either Group. As of December 31, 1998, the available dividend amount attributable to the Core Group, after payment of dividends on the Series B Preferred Stock, and the Psychiatric Group as of that date was at least $303.5 million and $6.4 million, respectively. All dividends on the Series B Preferred Stock and Common Stock will be deemed to be out of the Core Group's funds and all dividends on Psychiatric Group Stock will be deemed to be out of the Psychiatric Group's funds.
Dividends on Series B Preferred Stock, the Common Stock and the Psychiatric Group Stock will be further limited to the amount of funds of the Company legally available under Delaware law for the payment of dividends by the Company on its capital stock. As of December 31, 1998, the funds of the Company legally available for the payment of dividends would have been at least $309.9 million. Payments of dividends on any of the Series B Preferred Stock, the Common Stock or the Psychiatric Group Stock will decrease the amount of funds legally available for the payment of dividends on the Series B Preferred Stock, the Common Stock and the Psychiatric Group Stock.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Set forth below for the years ended December 31, 1998, 1997, 1996, 1995 and 1994 are (a) selected consolidated financial data with respect to the Company, (b) selected combined financial data for the Core Group, and (c) selected combined financial data for the Psychiatric Group. The selected financial data should be read in conjunction with the Consolidated, Core Group Combined and Psychiatric Group Combined Financial Statements and accompanying Notes included elsewhere herein.
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(1) Includes impairment loss of $8,330 in 1998, $11,000 in 1997 and $30,000 in 1994 on Psychiatric Group real estate and notes receivable.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Following is a discussion of the consolidated financial condition and results of operations of the Company, which should be read in conjunction with (a) the consolidated financial statements and accompanying notes of the Company and (b) management's discussion and analysis of financial condition and results of operations of the Core Group and the Psychiatric Group included elsewhere herein.
Factors Regarding Future Results and Forward-Looking Statements. This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators and tenants, the ability of an operator to continue operations of a psychiatric facility, plans with respect to individual facilities, expectations with respect to the specific terms of leases or sales of the Company's facilities, the Company's anticipated dividends, the potential redemption of the Psychiatric Group Depositary Shares, the Company's liquidity position, projected expenses associated with operating or maintaining individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned.
Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators and tenants of such facilities, the continuing ability of operators and tenants to meet their obligations to the Company, changes in operators or ownership of operators, the ability of operators and tenants to access short and long-term capital at acceptable rates, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' and tenants' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third-party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, the Company's ability to complete the proposed disposition of the Kendall Regional Medical Center property as a successful 1031 exchange in which the Company acquires investments providing a comparable rate of return, a downturn in market lease rates for medical office space, disruptions caused by the failure of the Company or its vendors, operators, lessees or borrowers, or the payors or other third parties upon which they are dependent, to resolve any Year 2000 Issues affecting their respective operations, higher than expected costs associated with the maintenance and operation of the Company's medical office/clinic facilities, higher than expected turnover at the Company's medical office/clinic facilities, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields, the adoption of new accounting standards and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of such factors, see "-- Future Operating Results" herein.
OPERATING RESULTS
1998 Compared to 1997
In 1998, the Company reported income before extraordinary item attributable to Core Group Common Stock and Psychiatric Group Depository Shares of $37,865,000, which included an impairment loss on
psychiatric real estate and notes receivable of ($8,330,000), compared with $36,636,000 in 1997, which included an impairment loss on psychiatric real estate and notes receivable of ($11,000,000). In 1998, the Company reported net income attributable to Core Group Common Stock and Psychiatric Group Depositary Shares of $37,865,000 compared with $25,209,000 in 1997. An extraordinary loss on debt prepayment of ($11,427,000) was reported in 1997. See the Consolidated Statements of Operations for the comparative gross and per share amounts attributable to the Core Group Common Stock and the Psychiatric Group Depositary Shares.
Rental income was $92,110,000 in 1998 an increase of $19,873,000 or 28% from $72,237,000 in 1997. This increase was primarily attributable to rental income from new Core Group properties acquired subsequent to the first quarter of 1997. These property additions also resulted in an increase in depreciation and amortization of $5,450,000 or 34% to $21,354,000 in 1998 compared with $15,904,000 in 1997.
Mortgage interest income was $3,542,000 in 1998, a decrease of $2,747,000 or 44% from $6,289,000 in 1997. On July 1, 1998, the Company received $35 million as payment in full of its Psychiatric Group's two Four Winds mortgage loans resulting in a decrease in mortgage interest income in 1998. The decrease is partially offset by interest income from a Core Group mortgage note receivable which was funded in the second quarter of 1997.
Additional rental and interest income was $14,098,000 in 1998, an increase of $1,600,000 or 13% from $12,498,000 in 1997. The increase in additional rental and interest income was attributable to increases in additional rent/interest of $1,513,000 from acute care properties, $140,000 from long-term care properties and $71,000 from psychiatric properties, partially offset by a $124,000 decrease in additional rent from rehabilitation properties.
Other property income of $2,099,000 in 1998 primarily represents property operating expense reimbursements and parking revenue from medical office/clinic facility tenants.
Other interest income decreased $1,381,000 or 61% to $873,000 in 1998 from $2,254,000 in 1997. The decrease in other interest income in 1998 resulted primarily from lower investable cash balances and a lower average balance of direct financing leases during 1998 compared to 1997. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. The decrease was partially offset by interest income from a subordinated note receivable due from the operator of an Alzheimer's care facility, which was funded during the second quarter of 1998, and interest income from the net proceeds of the Four Winds loans payoff during the month of July until such proceeds were used to execute a special dividend to holders of Psychiatric Group Depositary Shares on July 24, 1998.
Property operating expense was $5,769,000 in 1998, an increase of $5,245,000 from $524,000 in 1997. Approximately $4,985,000 of this increase was attributable to operating expenses of Core Group medical office/clinic facilities acquired subsequent to the first quarter of 1997 and $260,000 of the increase was attributable to costs related to the protection and maintenance of a closed psychiatric property in Florida.
Interest expense was $21,609,000 in 1998, an increase of $1,950,000 or 10% from $19,659,000 in 1997. This increase was primarily attributable to a higher average balance of bank credit facility borrowings and the assumption of two mortgage loans in connection with the acquisition of medical office/clinic facilities. The increase was partially offset by a higher level of capitalized interest in 1998 compared to 1997 and a lower weighted average effective interest rate on debt during 1998.
General and administrative expenses were $9,006,000 in 1998, an increase of $1,006,000 from $8,000,000 in 1997. This variation was primarily attributable to hiring of additional personnel, expansion of property management capabilities, higher compensation and benefits expense and increases in travel, legal and consulting expenses.
1997 Compared to 1996
In 1997, the Company reported income before extraordinary item attributable to Core Group Common Stock and Psychiatric Group Depositary Shares of $36,636,000, which included an impairment loss on psychiatric investments of ($11,000,000), compared with $44,379,000 in 1996. An extraordinary loss on debt prepayment of ($11,427,000) was reported in 1997. The Company reported net income attributable to Core Group Common Stock and Psychiatric Group Depositary Shares of $25,209,000 in 1997 compared with $44,379,000 in 1996. See the Consolidated Statements of Operations for the comparative gross and per share amounts attributable to the Core Group Common Stock and the Psychiatric Group Depositary Shares.
Rental income was $72,237,000 in 1997, an increase of $2,749,000 or 4% from $69,488,000 in 1996. This increase was primarily attributable to rental income from new Core Group properties acquired subsequent to the first quarter of 1996. These property additions also resulted in an increase in depreciation and amortization expense of $888,000 or 6% to $15,904,000 in 1997 compared with $15,016,000 in 1996.
Mortgage interest income was $6,289,000 in 1997, an increase of $309,000 or 5% from $5,980,000 in 1996. This increase was primarily attributable to the funding of a mortgage note receivable during 1997.
Additional rental and interest income was $12,498,000 in 1997, a net increase of $156,000 or 1% from $12,342,000 in 1996. This net increase was attributable to increases in additional rent of $143,000 from acute care properties, $91,000 from rehabilitation properties and $69,000 from long-term care properties, partially offset by a $146,000 decrease in additional rent and interest from psychiatric properties.
Other property income of $187,000 in 1997 represents property operating expense reimbursements from medical office/clinic facility tenants.
Other interest income increased $1,140,000 or 102% to $2,254,000 in 1997 from $1,114,000 in 1996. The increase in other interest income in 1997 was primarily attributable to higher investable cash balances, partially offset by a lower average balance of direct financing leases and a lower average balance of interest-earning borrowings outstanding under revolving credit facilities provided to a psychiatric hospital operator in 1997. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. In addition, the temporary investment of a portion of the proceeds of a preferred equity offering in October 1997 resulted in significantly higher investable cash balances during the fourth quarter of 1997.
Property operating expense was $524,000 in 1997, an increase of $480,000 from $44,000 in 1996. Approximately $290,000 of this increase was attributable to operating expenses of medical office/clinic facilities acquired during 1997 and $190,000 was attributable to costs related to the protection and maintenance of a psychiatric property in Florida, incurred after the hospital operator ceased hospital operations during the second quarter of 1997.
Interest expense was $19,659,000 in 1997, a decrease of $2,183,000 or 10% from $21,842,000 in 1996. The decrease in interest expense was primarily attributable to a lower weighted average effective interest rate on long-term debt during 1997, partially offset by a higher amount of long-term debt and a lower amount of capitalized interest in 1997. In late January 1997, the Company sold $220 million of publicly-traded unsecured senior notes with a weighted average effective interest rate of approximately 7.56%. The Company used the proceeds of this offering to pay off the borrowings under its bank credit facility outstanding at the time and to prepay $152 million of 11.03% private placement debt in late February 1997 prior to its scheduled maturity, incurring an extraordinary charge in the first quarter of 1997 of $11,427,000.
General and administrative expenses were $8,000,000 in 1997, an increase of $573,000 or 8% from $7,427,000 in 1996. This variation was primarily attributable to hiring of additional personnel, higher compensation and benefits expense and an increase in travel expense, partially offset by a reduction in director's fees and expenses, legal costs and shareholder reporting costs.
Future Operating Results
The operators and tenants of most of the Company's facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third-party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants also are subject to extensive federal, state and local government regulation relating to their operations, and most of the Company's facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third-party payors or an operator's or tenant's failure to maintain its certification under Medicare or Medicaid programs could adversely affect revenues to the Company's facilities.
The nature of health care delivery in the United States continues to undergo change and further review at both the national and state levels. Generally accepted goals of reform continue to include controlling costs and improving access to medical care. Various plans to decrease the growth in Medicare spending have been proposed and passed by both Houses of Congress. These plans generally include revisions to and limits on Medicare and federal programs providing Medicaid reimbursement to state health care programs and have had and potentially would have an adverse impact on the level of funds available in the future to health care facilities. The Balanced Budget Act of 1997 contains extensive changes to the Medicare and Medicaid programs intended to reduce the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. In addition, the Budget Act repealed certain limits on states' ability to reduce their Medicaid reimbursement levels. The Budget Act has the potential to reduce significantly federal spending on health care services provided at each of the Company's facilities and provided by the physician tenants of the Company's medical office/clinic facilities, and to affect revenues of the Company's operators and tenants adversely. In particular, the Budget Act's limitations on reimbursable costs and reductions in payment incentives and capital related payments, as well as the change toward a prospective payment system, may have a material adverse effect on operator revenues at the Company's rehabilitation, long-term acute care, and psychiatric hospitals. The Budget Act's freeze on acute care hospital reimbursement rates may also have an adverse effect on the operator revenues at the Company's acute care hospitals. In addition, the prospective payment system imposed by the Budget Act on the operators of the Company's skilled nursing facilities may have a material adverse effect on the operator revenues at such facilities if the operators are unable to effectively respond to the financial incentives provided by the prospective payment system. The Company cannot be assured that the changes effected by the Budget Act will not have a material adverse effect on the Company's financial condition or results of operation.
The Company's Board and management are monitoring the effect of the Budget Act and other regulatory activities on the Company's facilities and potential changes to reimbursement programs closely. The Company believes that the changes effected by the Budget Act and changes proposed at the federal and state level may pose risks for certain institutions and physician groups that are unwilling or unable to respond. At the same time, the Company believes that this changing health care environment will provide the Core Group with new opportunities for investment.
The ongoing changes in the health care industry include trends toward shorter lengths of hospital stay, increased use of outpatient services, increased federal, state and third-party oversight of health care company operations and business practices, and increased demand for discounted or capitated health care services (delivery of services at a fixed price per capita basis to a defined group of covered parties). Furthermore, federal, state and third-party payors continue to propose and adopt various cost containment measures that restrict the scope of reimbursable health care services and limit increases in reimbursement rates for such services. Payors also are continuing to enforce compliance with program requirements aggressively and to pursue providers that they believe have not complied with such requirements. Outpatient business is expected to increase as advances in medical technologies allow more procedures to be performed on an outpatient basis and as payors continue to direct more patients from inpatient care to outpatient care. In addition, the entrance of insurance companies into managed care programs is accelerating the introduction of managed care in new localities, and states and insurance companies continue to negotiate actively the amounts they will pay for
services. Moreover, the percentage of health care services that are reimbursed under the Medicare and Medicaid programs continues to increase as the population ages. States are also expanding their Medicaid programs. Continued eligibility to participate in these programs is crucial to a provider's financial strength. As a result of the foregoing, revenues and margins may decrease at the Company's facilities.
Notwithstanding the potential for increasing government regulation, the Company believes that health care will continue to be delivered on a local and regional basis and that well-managed, high-quality, cost-controlled facilities will continue to be an integral part of local and regional health care delivery systems. The Company also believes that certain acute care hospitals will need to reconfigure or expand existing facilities or to affiliate themselves with other providers so as to become part of comprehensive and cost-effective health care systems. Such systems likely will include lower cost treatment settings, such as ambulatory care clinics, outpatient surgery centers, long-term acute care hospitals, skilled nursing facilities, assisted living and Alzheimer's care facilities and medical office/clinic facilities. In general, the Core Group facilities are part of local or regional health care delivery systems or are in the process of becoming integrated into such systems.
The Company's future operating results could be affected by the operating performance of the Company's lessees and borrowers. The rental and interest obligations of its facility operators are primarily supported by the facility-specific operating cash flow. Real estate investments in the Company's portfolio are generally further supported by one or more credit enhancements that take the form of cross-default provisions, letters of credit, corporate and personal guarantees, security interests in cash reserve funds, accounts receivable or other personal property and requirements to maintain specified financial ratios.
Kendall Regional Medical Center (Kendall) is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). Aggregate revenues from the lease, which was originally scheduled to mature in February 1999, were approximately $10.3 million in 1998, or 9% of the Company's total revenues. Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at fair market value. The purchase price of $105 million will be paid in cash, or at the option of the Company, a combination of cash and debt relief. The Company currently intends to effect the transaction as a "deferred like-kind" 1031 exchange for tax purposes. The first part of the exchange, the transfer of Kendall to Columbia, is currently scheduled to occur on April 15, 1999. The Company would complete the exchange by acquiring new investment properties within the time limits imposed by federal tax law, if possible. If the Company is successful in identifying and closing on a sufficient amount of new investments within the required time limits, the Company should not recognize current taxable gain as a result of the transaction. In that event, there should be no impact on the Company's REIT distribution requirements. Even though the Company may not recognize gain on the transaction for tax purposes, the Company expects to be able to recognize a gain of over $50 million for book purposes. The Company cannot be assured that total revenues generated by new investments acquired to effect the exchange will equal the annual revenues currently generated by the Kendall investment, nor is it certain that the Company will complete the transaction as an exchange. If the Company does not complete the transaction as an exchange, the amount of the Company's tax liability, the impact on its REIT distribution requirements and the amount of gain, net of taxes, if any, recognized for book purposes would depend on the amount of gain recognized for tax purposes, any losses recognized by the Company on sales of other assets and various tax elections available to the Company.
The future operating results of the Company will be affected by additional factors including the amount, timing and yield of additional real estate investments and the competition for such investments. Operating results also will be affected by the availability and terms of the Company's future equity and debt financing. The Company's financing strategy to facilitate future growth includes initiatives intended to reduce its cost of capital over time and enhance its liquidity and financial flexibility. The Company's future earnings, cash flows and fair values relevant to financial instruments are dependent upon prevailing market rates. Market risk is the risk of loss from adverse changes in market prices and interest rates. The Company manages its market risk by matching projected cash inflows from operating properties, financing activities and investing activities with projected cash outflows to fund debt payments, acquisitions, capital expenditures, distributions and other cash requirements. Although in the past, the Company has occasionally utilized derivative financial instruments for hedging purposes, and may do so in the future in certain circumstances, generally the Company does not utilize derivative financial instruments for hedging purposes and does not use such instruments for trading
purposes. The Company utilizes debt and equity financing primarily for the purpose of making additional investments in health care facilities. Historically, the Company has made short-term variable rate borrowings under its unsecured revolving credit agreement to initially fund its acquisitions until market conditions were appropriate, based on management's judgement, to issue equity or fixed rate debt to provide long-term financing. Changes in interest rates on fixed rate debt generally affect fair market value, but not earnings or cash flows. The Company's ability to prepay fixed rate debt prior to maturity is generally limited, therefore, interest rate risk and changes in fair market value should not have a significant impact on the fixed rate debt until the maturity of such debt. The Company's earnings and cash flows are affected by changes in interest rates affecting its variable rate borrowings under its bank credit facility. At December 31, 1998, the Company had $69 million of such variable rate borrowings outstanding at a weighted average interest rate of 6.0%. Assuming this balance were to remain constant, each one percentage point increase or decrease in the weighted average interest rate on such variable rate borrowings would result in a corresponding increase or decrease in interest expense for 1999 of approximately $690,000. This estimate does not consider the effects of the change in the level of overall economic activity that could exist in such an environment of changing interest rates. Further, in the event of such a change, management would likely take further actions to mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Company's financial structure.
The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in the periodic restructuring of psychiatric operator payment obligations, the closing of one psychiatric hospital and significant impairment losses on psychiatric investments, including an $11 million charge in 1997 and a $8.3 million charge in 1998. At December 31, 1998, the aggregate carrying value of the Company's psychiatric properties was $5,131,000. The Northpointe property has been vacant since mid-1997 and has a carrying value of $1,300,000. The Company incurs ongoing costs for maintenance and security of the property while it continues to seek alternate uses or a buyer for the property. The operator of the Rock Creek Center (RCC) experienced continuing financial and operational difficulties over the past several years, and at the end of 1998, the operator was in default on its obligations to the Company. As a result, the carrying value of the RCC property was written down to $1,200,000 and the Company's net investment in related notes and various other obligations owed to it by the operator of RCC were totally written off. Subsequent to year-end, the Company sold its total RCC investment for a cash price of $2.5 million. At December 31, 1998, the Sunrise Regional Medical Center (Sunrise) property had a carrying value of $2,631,000. In September 1998, a new operator assumed all operational responsibility for the hospital and entered into a new five-year lease with effective monthly rent of $60,000. Although the new operator has fulfilled its obligations to the Company under the lease so far, the new operator has experienced cash flow difficulties primarily as a result of delays in obtaining Baker Act certification. As a result, the Company provided the operator with a $200,000 working capital loan at the end of 1998, and subsequent to year-end, the operator requested $700,000 of additional working capital loans. Although this request is still being evaluated, the Company likely will provide the additional loans. The Company cannot be assured that the operator will be successful and, if it were to cease operations, an impairment charge to reduce the carrying value of the Sunrise property and any related outstanding working capital loans would be likely. The Company will continue to encourage the operator to pursue financing alternatives that might enable it to acquire the property and repay its borrowings from the Company.
Dividends on the Company's Psychiatric Group Depositary Shares are determined each quarter based upon the operating results of the Company's Psychiatric Group. It continues to be the policy of the Board to maintain a dividend payout ratio for each quarter in excess of 90 percent of the Psychiatric Group's funds from operations for the related quarter, when possible. With the disposition of the RCC investment subsequent to year-end, the Sunrise investment is currently the sole income-producing property of the Company's Psychiatric Group and the operator of Sunrise is experiencing cash flow difficulties. Therefore, commencing in the second quarter of 1999, the Psychiatric Group's funds from operations may not be sufficient to permit the payment of a dividend on the Psychiatric Group Depositary Shares.
The Company intends to periodically evaluate the financial position of the Psychiatric Group, including an assessment of the potential cash requirements of the Psychiatric Group and the appropriate use of the
proceeds from the sale of the RCC investment. Initially, proceeds from the RCC disposition, net of closing costs and applicable reserves, will be retained by the Psychiatric Group to defray its ongoing costs, including the potential long-term costs of carrying the two remaining Psychiatric Group properties. The Psychiatric Group may continue to retain such proceeds or, alternatively, may distribute a portion of such net proceeds to holders of Psychiatric Group Depositary Shares, in cash or Core Group Common Stock, either by dividend or in connection with redemption of the Psychiatric Group Depositary Shares. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may elect to redeem the outstanding Psychiatric Group Depositary Shares in cash or in exchange for shares of Core Group Common Stock. Under the terms of the Certificate of Designations for the Psychiatric Group Preferred Stock and the Deposit Agreement providing for issuance of Depositary Receipts (Psychiatric Group Depositary Shares) each representing one-tenth of one share of the Psychiatric Group Preferred Stock, the Company has the right to redeem all outstanding Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, for cash (or in exchange for newly issued shares of Core Group Common Stock) at a premium generally ranging from 5% to 15% over the value of the Psychiatric Group Depositary Shares. Since an exchange or redemption of the Psychiatric Group Depositary Shares may be at a premium to the then current market price of the Psychiatric Group Depositary Shares, and since the Board could determine to effect such an exchange or redemption at a time when either or both the Core Group Common Stock and the Psychiatric Group Depositary Shares may be considered to be overvalued or undervalued, the exchange or redemption could be disadvantageous to the holders of the Core Group Common Stock or the Psychiatric Group Depositary Shares.
Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions (the Year 2000 Issue). The Company has a four-phase program to assess the impact upon the Company of the Year 2000 Issue and to remediate those Year 2000 Issues that may be discovered. The Company will monitor its progress in achieving the target completion dates established for each phase of the program. The first phase, a comprehensive inventory of the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, has been completed. The second phase, assessing the impact of the Year 2000 Issue with respect to the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, is essentially complete. The third phase, preparation and execution of a plan to remediate Year 2000 Issues identified in phases one and two, is expected to be completed during the second and third quarters of 1999. The fourth and final phase includes the development of contingency plans to address Year 2000 Issues that cannot be remediated. The timing for the fourth phase will depend upon the results of the second and third phases and, therefore, no schedule for the fourth phase can be set at this time. Since the Company is in the initial phases of its Year 2000 program, it is likewise currently unable to estimate the costs to remediate its Year 2000 Issues. The costs incurred to date have not been material and the Company does not expect the Year 2000 Issue to have a material impact on the Company's future operations or financial results.
Vendors that provide payroll, banking, communications and property management services to the Company and the Company's operators, lessees and borrowers will also likely be affected by the Year 2000 Issue. The future operations of the Company could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's vendors or its operators, lessees or borrowers do not adequately address their Year 2000 Issues. As health care providers, the Company's operators, lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. In addition, the delivery of patient care by providers requires utilization of critical clinical systems, medical devices and equipment that could be impacted by the Year 2000 Issue. Furthermore, the Company's operators, lessees and borrowers likewise are dependent on a variety of third parties, including but not limited to, insurance companies, HMO's and other private payors, governmental agencies, fiscal intermediaries that process claims and make payments for the Medicare and Medicaid programs, utilities that provide electricity, water, natural gas and communications services and vendors of medical supplies, pharmaceuticals, clinical systems, medical devices and equipment used in patient care, all of whom must also adequately address the Year 2000 Issue. The Company is reviewing publicly filed information of, sending questionnaires to and/or contacting its
vendors, operators, lessees and borrowers regarding their state of readiness with respect to identifying and remediating their Year 2000 Issues. However, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such vendors, operators, lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that third parties upon which the Company's vendors, operators, lessees and borrowers are dependent will accomplish adequate remediation of their Year 2000 Issues.
Although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, office equipment and the embedded building control systems in its multi-tenant properties, will not be material, the Company cannot be assured that the Year 2000 Issues of its vendors or its operators, lessees and borrowers and the third parties upon which they are dependent will not have a material impact on the future operations and/or financial results of the Company.
LIQUIDITY AND CAPITAL RESOURCES
As of March 18, 1999, the Company had a remaining commitment of approximately $2.5 million to fund the development of one skilled nursing facility. The Company's remaining commitment to fund the development of three assisted living facilities was approximately $8.0 million as of March 18, 1999. The Company has a $22.5 million forward funding commitment to develop up to nine Alzheimer's care facilities to be managed by the same operator that currently manages two existing Alzheimer's care facilities owned by the Company. As of March 18, 1999, $1.7 million was funded under this commitment for the development of two facilities having total development costs of approximately $5.6 million. The Company had a remaining commitment of $4.7 million as of March 18, 1999 to develop a medical office/clinic facility.
As of March 18, 1999, the Company had $75.0 million of outstanding borrowings under its $250 million bank credit facility and had $1.4 million in cash and short-term investments. The Company's total indebtedness as of March 18, 1999 was $314.8 million. The Company expects to utilize its bank credit facility to fund its future Core Group acquisitions and its other commitments. The Company may incur additional indebtedness or refinance existing indebtedness if the Company determines that opportunities to pursue such transactions would be attractive. The Company currently believes it has sufficient capital to meet its commitments and that its cash flow and liquidity will continue to be sufficient to fund current operations and to provide for the payment of dividends to stockholders in compliance with the applicable sections of the Internal Revenue Code governing real estate investment trusts.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF CORE GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Following is a discussion of the combined financial condition and results of operations of the Core Group, which should be read in conjunction with (a) the combined financial statements and accompanying notes of the Core Group and (b) management's discussion and analysis of financial condition and results of operations and the financial statements and accompanying notes of the Company and the Psychiatric Group included elsewhere herein.
Factors Regarding Future Results and Forward-Looking Statements. This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators and tenants, plans with respect to individual facilities, expectations with respect to the specific terms of leases or sales of the Company's facilities, the Company's anticipated dividends, the Company's liquidity position, projected expenses associated with operating or maintaining individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned.
Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators and tenants of such facilities, the continuing ability of operators and tenants to meet their obligations to the Company, changes in operators or ownership of operators, the ability of operators and tenants to access short and long-term capital at acceptable rates, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' and tenants' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third-party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, the Company's ability to complete the proposed disposition of the Kendall Regional Medical Center property as a successful 1031 exchange in which the Company acquires investments providing a comparable rate of return, a downturn in market lease rates for medical office space, disruptions caused by the failure of the Company or its vendors, operators, lessees or borrowers, or the payors or other third parties upon which they are dependent, to resolve any Year 2000 Issues affecting their respective operations, higher than expected costs associated with the maintenance and operation of the Company's medical office/clinic facilities, higher than expected turnover at the Company's medical office/clinic facilities, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields, the adoption of new accounting standards and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of such factors, see "-- Future Operating Results" herein.
OPERATING RESULTS
1998 Compared to 1997
In 1998, the Core Group reported income before extraordinary item attributable to Core Group Common Stock of $43,045,000, or $1.75 per share on a diluted basis, compared with $42,554,000 or $1.80 per share on a diluted basis, in 1997. In 1998, the Core Group reported net income attributable to Core Group Common
Stock of $43,045,000, or $1.75 per share on a diluted basis, compared with $31,127,000, or $1.31 per share on a diluted basis in 1997, which included an extraordinary loss on debt prepayment of ($11,427,000), or ($.49) per share on a diluted basis.
Rental income was $90,338,000 in 1998, an increase of $19,734,000 or 28% from $70,604,000 in 1997. This increase was primarily attributable to rental income from new properties acquired subsequent to the first quarter of 1997. These property additions also resulted in an increase in depreciation and amortization of $5,448,000 or 36% to $20,601,000 in 1998 compared with $15,153,000 in 1997.
Mortgage interest income was $464,000 in 1998, an increase of $247,000 from $217,000 in 1997. This increase was attributable to the funding of a mortgage note receivable in the second quarter of 1997.
Additional rental and interest income was $13,362,000 in 1998, an increase of $1,529,000 or 13% from $11,833,000 in 1997. The increase in additional rental and interest income was attributable to increases in additional rent of $1,513,000 from acute care properties and $140,000 from long-term care properties, partially offset by a $124,000 decrease in additional rent from rehabilitation properties.
Other property income of $2,099,000 in 1998, primarily represents property operating expense reimbursements and parking revenue from medical office/clinic facility tenants.
Other interest income decreased $1,334,000 or 70% to $574,000 in 1998 from $1,908,000 in 1997. The decrease in other interest income for 1998 resulted primarily from lower investable cash balances and a lower average balance of direct financing leases during 1998 compared to 1997. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. The decrease was partially offset by interest income from a subordinated note receivable due from the operator of an Alzheimer's care facility, which was funded during the second quarter of 1998.
Interest income on inter-Group loans to the Psychiatric Group was $712,000 in 1998, a decrease of $841,000 or 54% from $1,553,000 in 1997. This decrease is primarily attributable to the July 1, 1998 payoff of the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group.
Property operating expense was $5,319,000 in 1998, an increase of $4,985,000 from $334,000 in 1997. This increase was attributable to operating expenses associated with medical office/clinic facilities acquired subsequent to the first quarter 1997.
Interest expense was $21,609,000 in 1998, an increase of $1,950,000 or 10% from $19,659,000 in 1997. This increase was primarily attributable to a higher average balance of bank credit facility borrowings and the assumption of two mortgage loans in connection with the acquisition of medical office/clinic facilities. This increase was partially offset by a higher level of capitalized interest in 1998 compared to 1997 and a lower weighted average effective interest rate on debt during 1998.
Interest expense on inter-Group loans from the Psychiatric Group was $117,000 in 1998 as a result of revolving inter-Group loans made by the Psychiatric Group commencing July 1, 1998 with its available undistributed cash.
General and administrative expenses were $8,069,000 in 1998, an increase of $1,209,000 from $6,860,000 in 1997. This variation was attributable to an increase in the Company's consolidated general and administrative expenses which are allocated between the Core Group and Psychiatric Group primarily based on revenues, and an increase in Core Group revenues relative to the Company's consolidated revenues. The increase in the Company's consolidated general and administrative expenses affecting the Core Group was primarily attributable to hiring of additional personnel, expansion of property management capabilities, higher compensation and benefits expense and increases in travel, legal and consulting expenses.
1997 Compared to 1996
In 1997, the Core Group reported income before extraordinary item attributable to Core Group Common Stock of $42,554,000, or $1.80 per share on a diluted basis, an increase of $3,754,000 or 10% compared with $38,800,000, or $1.65 per share on a diluted basis, in 1996. An extraordinary loss on debt prepayment of ($11,427,000), or ($.49) per share on a diluted basis, was reported in 1997. The Core Group reported net income attributable to Core Group Common Stock of $31,127,000, or $1.31 per share on a diluted basis, in 1997 compared with $38,800,000, or $1.65 per share on a diluted basis, in 1996.
Rental income was $70,604,000 in 1997, an increase of $3,105,000 or 5% from $67,499,000 in 1996. This increase was primarily attributable to rental income from new properties acquired subsequent to the first quarter of 1996. These property additions also resulted in an increase in depreciation and amortization expense of $881,000 or 6% to $15,153,000 in 1997 compared with $14,272,000 in 1996.
Mortgage interest income of $217,000 in 1997 was attributable to the funding of a mortgage note receivable during 1997.
Additional rental income was $11,833,000 in 1997, an increase of $303,000 or 3% from $11,530,000 in 1996. This increase was attributable to increases in additional rent of $143,000 from acute care properties, $91,000 from rehabilitation properties and $69,000 from long-term care properties.
Other property income of $187,000 in 1997 represents property operating expense reimbursements from medical office/clinic facility tenants.
Other interest income increased $1,187,000 or 165% to $1,908,000 in 1997 from $721,000 in 1996. The increase in other interest income in 1997 was primarily attributable to higher investable cash balances, partially offset by a lower average balance of direct financing leases. Investable cash balances were significantly higher during the first quarter of 1997 due to the temporary investment of a portion of the proceeds of a public debt offering in late January 1997 until used to prepay the Company's private placement debt in late February 1997 after the prepayment notice period had expired. In addition, the temporary investment of a portion of the proceeds of a preferred equity offering in October 1997 resulted in significantly higher investable cash balances during the fourth quarter of 1997.
Interest income on inter-Group loans to the Psychiatric Group was $1,553,000 in 1997, a decrease of $126,000 or 8% from $1,679,000 in 1996. This decrease reflects a lower average balance outstanding on loans to the Psychiatric Group as a result of repayments by the Psychiatric Group from its available undistributed cash flow.
Property operating expense was $334,000 in 1997, an increase of $290,000 from $44,000 in 1996. This increase was attributable to operating expenses associated with investments in medical office/clinic facilities during 1997.
Interest expense was $19,659,000 in 1997, a decrease of $2,183,000 or 10% from $21,842,000 in 1996. The decrease in interest expense was primarily attributable to a lower weighted average effective interest rate on long-term debt during 1997, partially offset by a higher amount of long-term debt and a lower amount of capitalized interest in 1997. In late January 1997, the Company sold $220 million of publicly-traded unsecured senior notes with a weighted average effective interest rate of approximately 7.56%. The Company used the proceeds of this offering to pay off the borrowings under its bank credit facility outstanding at the time and to prepay $152 million of 11.03% private placement debt in late February 1997 prior to its scheduled maturity, incurring an extraordinary charge in the first quarter of 1997 of $11,427,000.
General and administrative expenses were $6,860,000 in 1997, an increase of $605,000 or 10% from $6,255,000 in 1996. This variation was attributable to an increase in the Company's consolidated general and administrative expenses which are allocated between the Core Group and Psychiatric Group primarily based on revenues, and an increase in Core Group revenues relative to the Company's consolidated revenues. The increase in the Company's consolidated general and administrative expenses affecting the Core Group was primarily attributable to hiring of additional personnel, higher compensation and benefits expense and an
increase in travel expense, partially offset by a reduction in director's fees and expenses, legal costs and shareholder reporting costs.
Future Operating Results
The operators and tenants of most of the Company's facilities derive a substantial percentage of their total revenues from federal and state health care programs such as Medicare and Medicaid and from other third-party payors such as private insurance companies, self-insured employers and health maintenance organizations. Such operators and tenants also are subject to extensive federal, state and local government regulation relating to their operations, and most of the Company's facilities are subject to periodic inspection by governmental and other authorities to assure continued compliance with mandated procedures, licensure requirements under state law and certification standards under the Medicare and Medicaid programs. A reduction in reimbursement levels under the Medicare or Medicaid programs, a reduction in reimbursement by other third-party payors or an operator's or tenant's failure to maintain its certification under Medicare or Medicaid programs could adversely affect revenues to the Company's facilities.
The nature of health care delivery in the United States continues to undergo change and further review at both the national and state levels. Generally accepted goals of reform continue to include controlling costs and improving access to medical care. Various plans to decrease the growth in Medicare spending have been proposed and passed by both Houses of Congress. These plans generally include revisions to and limits on Medicare and federal programs providing Medicaid reimbursement to state health care programs and have had and potentially would have an adverse impact on the level of funds available in the future to health care facilities. The Balanced Budget Act of 1997 contains extensive changes to the Medicare and Medicaid programs intended to reduce the projected amount of increase in Medicare spending by an estimated $115 billion and Medicaid spending by an estimated $13 billion over five years. In addition, the Budget Act repealed certain limits on states' ability to reduce their Medicaid reimbursement levels. The Budget Act has the potential to reduce significantly federal spending on health care services provided at each of the Core Group's facilities and provided by the physician tenants of the Core Group's medical office/clinic facilities, and to affect revenues of the Core Group's operators and tenants adversely. In particular, the Budget Act's limitations on reimbursable costs and reductions in payment incentives and capital related payments, as well as the change toward a prospective payment system, may have a material adverse effect on operator revenues at the Core Group's rehabilitation and long-term acute care hospitals. The Budget Act's freeze on acute care hospital reimbursement rates may also have an adverse effect on the operator revenues at the Core Group's acute care hospitals. In addition, the prospective payment system imposed by the Budget Act on the operators of the Core Group's skilled nursing facilities may have a material adverse effect on the operator revenues at such facilities if the operators are unable to effectively respond to the financial incentives provided by the prospective payment system. The Company cannot be assured that the changes effected by the Budget Act will not have a material adverse effect on the Core Group's financial condition or results of operation.
The Company's Board and management are monitoring the effect of the Budget Act and other regulatory activities on the Core Group's facilities and potential changes to reimbursement programs closely. The Company believes that the changes effected by the Budget Act and changes proposed at the federal and state level may pose risks for certain institutions and physician groups that are unwilling or unable to respond. At the same time, the Company believes that this changing health care environment will provide the Core Group with new opportunities for investment.
The ongoing changes in the health care industry include trends toward shorter lengths of hospital stay, increased use of outpatient services, increased federal, state and third-party oversight of health care company operations and business practices, and increased demand for discounted or capitated health care services (delivery of services at a fixed price per capita basis to a defined group of covered parties). Furthermore, federal, state and third-party payors continue to propose and adopt various cost containment measures that restrict the scope of reimbursable health care services and limit increases in reimbursement rates for such services. Payors also are continuing to enforce compliance with program requirements aggressively and to pursue providers that they believe have not complied with such requirements. Outpatient business is expected to increase as advances in medical technologies allow more procedures to be performed on an outpatient basis
and as payors continue to direct more patients from inpatient care to outpatient care. In addition, the entrance of insurance companies into managed care programs is accelerating the introduction of managed care in new localities, and states and insurance companies continue to negotiate actively the amounts they will pay for services. Moreover, the percentage of health care services that are reimbursed under the Medicare and Medicaid programs continues to increase as the population ages. States are also expanding their Medicaid programs. Continued eligibility to participate in these programs is crucial to a provider's financial strength. As a result of the foregoing, revenues and margins may decrease at the Core Group's facilities.
Notwithstanding the potential for increasing government regulation, the Company believes that health care will continue to be delivered on a local and regional basis and that well-managed, high-quality, cost-controlled facilities will continue to be an integral part of local and regional health care delivery systems. The Company also believes that certain acute care hospitals will need to reconfigure or expand existing facilities or to affiliate themselves with other providers so as to become part of comprehensive and cost-effective health care systems. Such systems likely will include lower cost treatment settings, such as ambulatory care clinics, outpatient surgery centers, long-term acute care hospitals, skilled nursing facilities, assisted living and Alzheimer's care facilities and medical office/clinic facilities. In general, the Core Group facilities are part of local or regional health care delivery systems or are in the process of becoming integrated into such systems.
The Core Group's future operating results could be affected by the operating performance of the Core Group's lessees and borrowers. The rental and interest obligations of its facility operators are primarily supported by the facility-specific operating cash flow. Real estate investments in the Core Group's portfolio are generally further supported by one or more credit enhancements that take the form of cross-default provisions, letters of credit, corporate and personal guarantees, security interests in cash reserve funds, accounts receivable or other personal property and requirements to maintain specified financial ratios.
Kendall Regional Medical Center (Kendall) is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). Aggregate revenues from the lease, which was originally scheduled to mature in February 1999, were approximately $10.3 million in 1998, or 10% of the Core Group's total revenues. Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at fair market value. The purchase price of $105 million will be paid in cash, or at the option of the Company, a combination of cash and debt relief. The Company currently intends to effect the transaction as a "deferred like-kind" 1031 exchange for tax purposes. The first part of the exchange, the transfer of Kendall to Columbia, is currently scheduled to occur on April 15, 1999. The Company would complete the exchange by acquiring new investment properties within the time limits imposed by federal tax law, if possible. If the Company is successful in identifying and closing on a sufficient amount of new investments within the required time limits, the Company should not recognize current taxable gain as a result of the transaction. In that event, there should be no impact on the Company's REIT distribution requirements. Even though the Company may not recognize gain on the transaction for tax purposes, the Core Group expects to be able to recognize a gain of over $50 million for book purposes. The Company cannot be assured that total revenues generated by new investments acquired to effect the exchange will equal the annual revenues currently generated by the Kendall investment, nor is it certain that the Company will complete the transaction as an exchange. If the Company does not complete the transaction as an exchange, the amount of the Company's tax liability, the impact on its REIT distribution requirements and the amount of gain, net of taxes, if any, recognized for book purposes would depend on the amount of gain recognized for tax purposes, any losses recognized by the Company on sales of other assets and various tax elections available to the Company.
The future operating results of the Core Group will be affected by additional factors including the amount, timing and yield of additional real estate investments and the competition for such investments. Operating results also will be affected by the availability and terms of the Company's future equity and debt financing. The Company's financing strategy to facilitate future growth includes initiatives intended to reduce its cost of capital over time and enhance its liquidity and financial flexibility. The Core Group's future earnings, cash flows and fair values relevant to financial instruments are dependent upon prevailing market rates. Market risk is the risk of loss from adverse changes in market prices and interest rates. The Core Group manages its market risk by matching projected cash inflows from operating properties, financing activities and investing activities with projected cash outflows to fund debt payments, acquisitions, capital expenditures,
distributions and other cash requirements. Although in the past, the Core Group has occasionally utilized derivative financial instruments for hedging purposes, and may do so in the future in certain circumstances, generally the Core Group does not utilize derivative financial instruments for hedging purposes and does not use such instruments for trading purposes. The Core Group utilizes debt and equity financing primarily for the purpose of making additional investments in health care facilities. Historically, the Core Group has made short-term variable rate borrowings under its unsecured revolving credit agreement to initially fund its acquisitions until market conditions were appropriate, based on management's judgement, to issue equity or fixed rate debt to provide long-term financing. Changes in interest rates on fixed rate debt generally affect fair market value, but not earnings or cash flows. The Core Group's ability to prepay fixed rate debt prior to maturity is generally limited, therefore, interest rate risk and changes in fair market value should not have a significant impact on the fixed rate debt until the maturity of such debt. The Core Group's earnings and cash flows are affected by changes in interest rates affecting its variable rate borrowings under its bank credit facility and its inter-Group variable rate borrowings from the Psychiatric Group. At December 31, 1998, the Company had $69.2 million of such variable rate borrowings outstanding at a weighted average interest rate of 6.0%. Assuming this balance were to remain constant, each one percentage point increase or decrease in the weighted average interest rate on such variable rate borrowings would result in a corresponding increase or decrease in interest expense for 1999 of approximately $692,000. This estimate does not consider the effects of the change in the level of overall economic activity that could exist in such an environment of changing interest rates. Further, in the event of such a change, management would likely take further actions to mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, this analysis assumes no changes in the Core Group's financial structure.
Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions (the Year 2000 Issue). The Company has a four-phase program to assess the impact upon the Company of the Year 2000 Issue and to remediate those Year 2000 Issues that may be discovered. The Company will monitor its progress in achieving the target completion dates established for each phase of the program. The first phase, a comprehensive inventory of the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, has been completed. The second phase, assessing the impact of the Year 2000 Issue with respect to the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, is essentially complete. The third phase, preparation and execution of a plan to remediate Year 2000 Issues identified in phases one and two, is expected to be completed during the second and third quarters of 1999. The fourth and final phase includes the development of contingency plans to address Year 2000 Issues that cannot be remediated. The timing for the fourth phase will depend upon the results of the second and third phases and, therefore, no schedule for the fourth phase can be set at this time. Since the Company is in the initial phases of its Year 2000 program, it is likewise currently unable to estimate the costs to remediate its Year 2000 Issues. The costs incurred to date have not been material and the Company does not expect the Year 2000 Issue to have a material impact on the Company's future operations or financial results.
Vendors that provide payroll, banking, communications and property management services to the Company and the Company's operators, lessees and borrowers will also likely be affected by the Year 2000 Issue. The future operations of the Company could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's vendors or its operators, lessees or borrowers do not adequately address their Year 2000 Issues. As health care providers, the Company's operators, lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. In addition, the delivery of patient care by providers requires utilization of critical clinical systems, medical devices and equipment that could be impacted by the Year 2000 Issue. Furthermore, the Company's operators, lessees and borrowers likewise are dependent on a variety of third parties, including but not limited to, insurance companies, HMO's and other private payors, governmental agencies, fiscal intermediaries that process claims and make payments for the Medicare and Medicaid programs, utilities that provide electricity, water, natural gas and communications services and vendors of medical supplies, pharmaceuticals, clinical systems, medical devices and equipment used in patient care, all of whom must also adequately address the Year 2000 Issue.
The Company is reviewing publicly filed information of, sending questionnaires to and/or contacting its vendors, operators, lessees and borrowers regarding their state of readiness with respect to identifying and remediating their Year 2000 Issues. However, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such vendors, operators, lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that third parties upon which the Company's vendors, operators, lessees and borrowers are dependent will accomplish adequate remediation of their Year 2000 Issues.
Although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, office equipment and the embedded building control systems in its multi-tenant properties, will not be material, the Company cannot be assured that the Year 2000 Issues of its vendors or its operators, lessees and borrowers and the third parties upon which they are dependent will not have a material impact on the future operations and/or financial results of the Company.
LIQUIDITY AND CAPITAL RESOURCES
As of March 18, 1999, the Core Group had a remaining commitment of approximately $2.5 million to fund the development of one skilled nursing facility. The Core Group's remaining commitment to fund the development of three assisted living facilities was approximately $8.0 million as of March 18, 1999. The Core Group has a $22.5 million forward funding commitment to develop up to nine Alzheimer's care facilities to be managed by the same operator that currently manages two existing Alzheimer's care facilities owned by the Core Group. As of March 18, 1999, $1.7 million was funded under this commitment for the development of two facilities having total development costs of approximately $5.6 million. The Core Group had a remaining commitment of $4.7 million as of March 18, 1999 to develop a medical office/clinic facility.
As of March 18, 1999, $75.0 million of outstanding borrowings under the Company's $250 million bank credit facility and $1.0 million in cash and short-term investments were attributed to the Core Group. Including $3.8 million of inter-Group borrowings from the Psychiatric Group, the total indebtedness attributed to the Company's Core Group as of March 18, 1999 was $318.6 million. The Company expects to utilize its bank credit facility to fund its future Core Group acquisitions and its other commitments. The Company may incur additional indebtedness or refinance existing indebtedness if the Company determines that opportunities to pursue such transactions would be attractive. The Company currently believes it has sufficient capital to meet its commitments and that its cash flow and liquidity will continue to be sufficient to fund current operations and to provide for the payment of dividends to stockholders in compliance with the applicable sections of the Internal Revenue Code governing real estate investment trusts.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF PSYCHIATRIC GROUP COMBINED FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Following is a discussion of the combined financial condition and results of operations of the Psychiatric Group, which should be read in conjunction with (a) the combined financial statements and accompanying notes of the Psychiatric Group and (b) management's discussion and analysis of financial condition and results of operations and the financial statements and accompanying notes of the Company and the Core Group included elsewhere herein.
Factors Regarding Future Results and Forward-Looking Statements. This report includes and incorporates by reference statements that are not purely historical and are "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding the Company's expectations, beliefs, intentions or strategies regarding the future. All statements other than historical fact contained in this report, including without limitation statements regarding rent or interest to be received from the Company's operators, the ability of an operator to continue operations of a psychiatric facility, plans with respect to individual facilities, expectations with respect to the specific terms of leases or sales of the Company's facilities, the Company's anticipated dividends, the potential redemption of the Psychiatric Group Depositary Shares, the Company's liquidity position, projected expenses associated with operating or maintaining individual properties, the Company's ability to realize the recorded amounts of its investments and the potential effect of new or existing regulations on the operations conducted at the Company's facilities, are forward-looking statements. All forward-looking statements included or incorporated by reference in this report are based on information available to the Company on the date hereof, and the Company assumes no obligation to update such forward-looking statements. Although the Company believes that the assumptions and expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct or that the Company will take any actions that may presently be planned.
Certain factors that could cause actual results to differ materially from those expected include, among others: the financial success of the operations conducted at the Company's facilities and the financial strength of the operators of such facilities, the continuing ability of operators to meet their obligations to the Company, changes in operators or ownership of operators, the ability of operators and tenants to access short and long-term capital at acceptable rates, the viability of alternative uses for the Company's properties when necessary, changes in government policy relating to the health care industry including reductions in reimbursement levels under the Medicare and Medicaid programs, operators' continued eligibility to participate in the Medicare or Medicaid programs, reductions in reimbursement by other third-party payors, the impact of managed care pricing pressures, the requirement to provide care on a fixed-price basis, lower occupancy levels at the Company's facilities, disruptions caused by the failure of the Company or its vendors, operators, lessees or borrowers, or the payors or other third parties upon which they are dependent, to resolve any Year 2000 Issues affecting their respective operations, a reduction in demand for the services provided at the Company's facilities, the strength and financial resources of the Company's competitors, the availability and cost of capital, the Company's ability to make additional real estate investments at attractive yields, the adoption of new accounting standards and changes in tax laws and regulations affecting real estate investment trusts. For a further discussion of such factors, see "-- Analysis of Psychiatric Group" herein.
OPERATING RESULTS
1998 Compared to 1997
In 1998, the Psychiatric Group reported a net loss of ($5,180,000), or ($2.49) per depositary share on a diluted basis, compared with a net loss of ($5,918,000), or ($2.84) per depositary share on a diluted basis, in 1997. The net loss for the year ended December 31, 1998 includes an impairment loss on real estate and mortgage notes receivable of ($8,330,000), or ($4.00) per depositary share on a diluted basis. The net loss in 1997 includes an impairment loss on real estate and notes receivable of ($11,000,000), or ($5.28) per depositary share on a diluted basis.
Rental income was $1,772,000 in 1998, an increase of $139,000 or 9% from $1,633,000 in 1997. This increase is primarily attributable to a one-time payment of $347,000 received from the previous operator of Sunrise to settle certain of the obligations it owes to the Psychiatric Group. Excluding this one-time payment, rental income decreased due to a net decrease in base rent payments made by Sunrise during 1998 as the result of a lease restructuring early in the fourth quarter of 1997 and the receipt of one month's base rent in the first quarter of 1997 from Northpointe before the operator stopped paying rent and subsequently ceased operations in the second quarter of 1997.
Mortgage interest income was $3,078,000 in 1998, a decrease of $2,994,000 or 49% from $6,072,000 in 1997. On July 1, 1998, the Psychiatric Group received $35 million as payment in full of its two Four Winds mortgage loans resulting in a decrease in mortgage interest income in 1998.
Additional rental and interest income was $736,000 in 1998, an increase of $71,000 or 11% from $665,000 in 1997. This increase was primarily attributable to an increase in additional interest received from the Four Winds Hospital -- Katonah facility and additional rent received from Rock Creek Center in 1998, partially offset by a decrease in additional interest resulting from the $35 million payoff of the two Four Winds mortgage loans in July 1998.
Other interest income was $299,000 in 1998, a decrease of $47,000 or 14% from $346,000 in 1997. This decrease was attributable to the nonpayment of interest on the Rock Creek Center revolving credit agreement in November and December 1998, partially offset by interest income on a portion of the net proceeds of the Four Winds mortgage loans payoff during the month of July until such proceeds were used to execute a special dividend on July 24, 1998.
Interest income on inter-Group loans to the Core Group was $117,000 in 1998 as a result of revolving inter-Group loans made by the Psychiatric Group commencing July 1, 1998 with its available undistributed cash.
Property operating expense of $450,000 in 1998 represents costs related to the protection and maintenance of Northpointe, incurred after the operator ceased operations in the second quarter of 1997.
Interest expense on inter-Group loans from the Core Group was $712,000 in 1998, a decrease of $841,000 or 54% from $1,553,000 in 1997. This decrease is attributable to the payoff of the entire $11.2 million outstanding balance of inter-Group loans owed to the Core Group by the Psychiatric Group using a portion of the $35 million received by the Psychiatric Group from the payoff of its two Four Winds mortgage loans on July 1, 1998.
General and administrative expenses were $937,000 in 1998, a decrease of $203,000 or 18% from $1,140,000 in 1997. The Company's consolidated general and administrative expenses are allocated between the Core Group and Psychiatric Group primarily based on revenues and are subject to a minimum of $62,500 per quarter, however significant costs directly related to either Group are specifically charged to the applicable Group. Costs allocated to the Psychiatric Group and direct costs charged to the Psychiatric Group both decreased in 1998 compared to 1997. The Psychiatric Group was specifically charged $438,000 in 1998 for financial advisory services provided primarily by an investment banking firm which included supplemental monitoring of the performance of the Psychiatric Group's properties and assistance in addressing operational and cash flow difficulties of certain operators of the properties. On a comparative basis, general and administrative expenses in 1997 included $463,000 of such financial advisory costs.
1997 Compared to 1996
In 1997, the Psychiatric Group reported a net loss of ($5,918,000), or ($2.84) per Psychiatric Group Depositary Share on a diluted basis, compared with net income of $5,579,000, or $2.67 per Psychiatric Group Depositary Share on a diluted basis, in 1996. The net loss in 1997 included an impairment loss on real estate investments and other notes receivable of ($11,000,000), or ($5.28) per Psychiatric Group Depositary Share on a diluted basis.
Rental income was $1,633,000 in 1997, a decrease of $356,000 or 18% from $1,989,000 in 1996. The decrease in rental income was primarily attributable to the nonpayment and subsequent reduction of base rent on one of the Florida properties during 1997, partially offset by the partial deferral of base rent on the Illinois property during 1996.
Additional rental and interest income was $665,000 in 1997, a decrease of $147,000 or 18% from $812,000 in 1996. This decrease was primarily attributable to the nonpayment of additional rent by one of the Florida properties during 1997.
Other interest income decreased $47,000 or 12% to $346,000 in 1997 from $393,000 in 1996. The decrease in other interest income was primarily attributable to a lower average balance of interest-earning borrowings outstanding under revolving credit facilities provided to psychiatric hospital operators in 1997.
Property operating expense of $190,000 in 1997 represents costs related to the protection and maintenance of one of the properties in Florida, incurred after the hospital owner ceased hospital operations during the second quarter of 1997.
Interest expense on inter-Group loans from the Core Group was $1,553,000 in 1997, a decrease of $126,000 or 8% from $1,679,000 in 1996. This decrease reflects a lower average balance outstanding on loans from the Core Group as a result of repayments by the Psychiatric Group from its available undistributed cash flow.
General and administrative expenses were $1,140,000 in 1997, a decrease of $32,000 or 3% from $1,172,000 in 1996. The Company's consolidated general and administrative expenses are allocated between the Core Group and Psychiatric Group primarily based on revenues, however significant costs directly related to either Group are specifically charged to the applicable Group. Costs allocated to the Psychiatric Group based on revenues and direct costs charged to the Psychiatric Group both decreased in 1997 compared to 1996. The Psychiatric Group was specifically charged for $463,000 in 1997 for financial advisory services provided primarily by an investment banking firm which included supplemental monitoring of the performance of the Psychiatric Group's properties and assistance in addressing operational and cash flow difficulties of certain operators of the properties. On a comparative basis, general and administrative expenses in 1996 included $467,000 of such financial advisory costs.
Analysis of Psychiatric Group
The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in the periodic restructuring of psychiatric operator payment obligations, the closing of one psychiatric hospital and significant impairment losses on psychiatric investments, including an $11 million charge in 1997 and a $8.3 million charge in 1998.
In late 1995, the operator of the Northpointe and Sunrise Regional Medical Center (Sunrise) facilities was experiencing operational and cash flow difficulties which negatively impacted the operator's ability to pay rental and interest obligations to the Psychiatric Group. During 1996, the Psychiatric Group modified the Northpointe agreements to allow for the deferral of rent and interest payments while certain restructuring and restaffing of the facility occurred. In late 1996, adverse publicity from a lawsuit filed against the operator alleging widespread irregularities materially exacerbated the operational and financial difficulties of Northpointe and Sunrise. Subsequently, the census at Northpointe fell significantly to a level that made it appear unlikely that the operator could continue operations at the facility and the operator was unable to continue paying its obligations to the Psychiatric Group after January 1997. Sunrise suffered from declining census and significant deterioration of its cash flow, which made it difficult to continue paying its obligations to the Psychiatric Group. The volatile circumstances at Sunrise and the deterioration in its cash flows and census levels appeared likely to preclude the operator from continuing operations at the facility. A range of options for these two facilities was explored, including the transfer of the operations to new operators, closing the facilities, conversion of the facilities to an alternative use or sale of the properties. As a result of this review, the Psychiatric Group recorded an $11,000,000 charge in the first quarter of 1997 for impairment of the carrying value of these two investments. Of this amount, $5,100,000 related to the Psychiatric Group's
investment in Northpointe, which included a $1,675,000 reserve against the entire unpaid balance under a revolving credit agreement and a $3,425,000 reduction in the carrying value of its net real estate investment. The remaining impairment charge of $5,900,000 related to the Psychiatric Group's investment in Sunrise, which included a $49,000 reserve against the entire unpaid balance under a revolving credit agreement and a $5,851,000 reduction in the carrying value of its net real estate investment. The financial and operational problems at the Northpointe and Sunrise facilities continued to worsen during 1997. The operator of Northpointe ceased hospital operations during the second quarter of 1997 and a restructuring of Sunrise's obligations to the Psychiatric Group was completed in the fourth quarter of 1997.
The Northpointe property remained vacant during 1998 and the Psychiatric Group incurred $450,000 ($.22 per depositary share on a diluted basis) of maintenance and security costs. Although the Psychiatric Group expects to incur approximately $75,000 per quarter for ongoing maintenance and security costs while it continues to seek alternate uses or a buyer for the property, the Psychiatric Group cannot be assured that other unexpected costs will not be incurred. Attempts to locate an alternate healthcare operator for the Northpointe property have proven largely unsuccessful. After assessing the various alternatives for the facility and reviewing the estimated net realizable value of the property under each potential alternative, the Psychiatric Group recorded an impairment charge at the end of 1998, which reduced the carrying value of the investment to $1,300,000. If an acceptable healthcare operator is not identified for the Northpointe facility in the near term, the property will likely be marketed for sale. However, the Psychiatric Group cannot be assured that any sale price would equal or exceed the current carrying value of the Northpointe property.
At December 31, 1998, the Sunrise property had a carrying value of $2,631,000. In September 1998, a new operator assumed all operational responsibility for the hospital and entered into a new five-year lease with effective monthly rent of $60,000 ($.029 per depositary share on a diluted basis). In connection with the change in operators, the Psychiatric Group received a one-time payment of $347,000 ($.17 per depositary share on a diluted basis) from the former operator to settle certain of the obligations owed to the Psychiatric Group. Although the new operator has fulfilled its obligations to the Psychiatric Group under the lease so far, the new operator has experienced cash flow difficulties primarily as a result of delays in obtaining Baker Act certification. As a result, the Psychiatric Group provided the operator with a $200,000 working capital loan at the end of 1998, and subsequent to year-end, the operator requested $700,000 of additional working capital loans. Although this request is still being evaluated, the Company likely will provide the additional loans. The Company cannot be assured that the operator will be successful and, if it were to cease operations, an impairment charge to reduce the carrying value of the Sunrise property and any related outstanding working capital loans would be likely. The Company will continue to encourage the operator to pursue financing alternatives that might enable it to acquire the property and repay its borrowings from the Company.
The operator of Rock Creek Center (RCC) experienced continuing financial and operational difficulties over the past several years. In 1996, RCC experienced substantial payor reimbursement issues and lower than expected census that adversely impacted its cash flow and its ability to pay its rental and interest obligations to the Psychiatric Group. As a result, the Psychiatric Group modified the RCC agreements in 1996 to allow for the partial deferral of base rent payments while the operator took certain actions to stabilize operations and implemented its revised business plan. The maturity date of the $2.5 million balance outstanding under the RCC revolving credit agreement and the initial term of the RCC lease were extended on several occasions with the latest extension to March 31, 1999. In June 1998, the operator of the RCC facility informed the Psychiatric Group that it had incurred a material, unanticipated liability to Medicare, which imperiled the continuing operation of the facility. RCC met its rent and interest obligations to the Psychiatric Group through November 1998, however, RCC made its November payments late due to cash flow problems. In December 1998, cash flow problems at RCC became so severe that the operator of the RCC facility defaulted on all of its obligations to the Psychiatric Group and the Psychiatric Group delivered formal notice of default to RCC for failure to pay such obligations. Although RCC had been involved in negotiations to effect a transfer of its operations, those negotiations were discontinued. As a result, the carrying value of the RCC property was written down to $1,200,000 and the Company's net investment in related notes and various other obligations owed to it by the operator of RCC were totally written off. Subsequent to year-end, on February 24, 1999, the Psychiatric Group sold its total RCC investment to the current operator for a cash
price of $2.5 million. The Company considered other alternatives for the property and evaluated offers from other potential buyers before agreeing to sell to the current operator. The sale to the current operator represented the highest price and most certain transaction the Psychiatric Group was able to achieve from qualified potential purchasers of the property.
On July 1, 1998, the Psychiatric Group received $35 million as prepayment in full of the two Four Winds mortgage notes receivable resulting in an impairment loss of $2.73 million. The proceeds from the payment of the Four Winds notes were first used by the Psychiatric Group to repay the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Company's Core Group and to maintain a cash reserve of approximately $2.3 million for the net current liabilities of the Psychiatric Group. On July 24, 1998, the Psychiatric Group used substantially all of the remaining proceeds to purchase 833,067 new shares of Core Group Common Stock from the Company's Core Group at a price of $25.9407 per share, which were concurrently distributed to holders of Psychiatric Group Depositary Shares as a special stock dividend. Holders of Psychiatric Group Depositary Shares received 0.4 shares of Core Group Common Stock for each Psychiatric Group Depositary Share held and were paid cash-in-lieu of fractional shares of Core Group Common Stock based on the price of $25.9407.
Market risk is the risk of loss from adverse changes in market prices and interest rates. Since the Psychiatric Group currently has no outstanding debt, mortgage loans or commitments and since it has no plans to incur debt, issue equity or make additional real estate investments, the Psychiatric Group is not effected by changes in market prices and interest rates. The Psychiatric Group does not utilize derivative financial instruments either for trading or hedging purposes.
Dividends on the Company's Psychiatric Group Depositary Shares are determined each quarter based upon the operating results of the Company's Psychiatric Group. It continues to be the policy of the Board to maintain a dividend payout ratio for each quarter in excess of 90 percent of the Psychiatric Group's funds from operations for the related quarter, when possible. With the disposition of the RCC investment, on February 24, 1999, the Sunrise investment is currently the sole income-producing property of the Company's Psychiatric Group and the operator of Sunrise is experiencing cash flow difficulties. Therefore, commencing in the second quarter of 1999, the Psychiatric Group's funds from operations may not be sufficient to permit the payment of a dividend on the Psychiatric Group Depositary Shares.
The Company intends to periodically evaluate the financial position of the Psychiatric Group, including an assessment of the potential cash requirements of the Psychiatric Group and the appropriate use of the proceeds from the February 24, 1999 sale of the RCC investment. Initially, proceeds from the RCC disposition, net of closing costs and applicable reserves, will be retained by the Psychiatric Group to defray its ongoing costs, including the potential long-term costs of carrying the two remaining Psychiatric Group properties. The Psychiatric Group may continue to retain such proceeds or, alternatively, may distribute a portion of such net proceeds to holders of Psychiatric Group Depositary Shares, in cash or Core Group Common Stock, either by dividend or in connection with redemption of the Psychiatric Group Depositary Shares. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may elect to redeem the outstanding Psychiatric Group Depositary Shares in cash or in exchange for shares of Core Group Common Stock. Under the terms of the Certificate of Designations for the Psychiatric Group Preferred Stock and the Deposit Agreement providing for issuance of Depositary Receipts (Psychiatric Group Depositary Shares) each representing one-tenth of one share of the Psychiatric Group Preferred Stock, the Company has the right to redeem all outstanding Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, for cash (or in exchange for newly issued shares of Core Group Common Stock) at a premium generally ranging from 5% to 15% over the value of the Psychiatric Group Depositary Shares. Since an exchange or redemption of the Psychiatric Group Depositary Shares may be at a premium to the then current market price of the Psychiatric Group Depositary Shares, and since the Board could determine to effect such an exchange or redemption at a time when either or both the Core Group Common Stock and the Psychiatric Group Depositary Shares may be considered to be overvalued or undervalued, the exchange or redemption could be disadvantageous to the holders of the Core Group Common Stock or the Psychiatric Group Depositary Shares.
Many existing information systems currently record years in a two-digit format and will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions (the Year 2000 Issue). The Company has a four-phase program to assess the impact upon the Company of the Year 2000 Issue and to remediate those Year 2000 Issues that may be discovered. The Company will monitor its progress in achieving the target completion dates established for each phase of the program. The first phase, a comprehensive inventory of the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, has been completed. The second phase, assessing the impact of the Year 2000 Issue with respect to the Company's internal information systems, office equipment and the embedded building control systems in the Company's multi-tenant properties, is essentially complete. The third phase, preparation and execution of a plan to remediate Year 2000 Issues identified in phases one and two, is expected to be completed during the second and third quarters of 1999. The fourth and final phase includes the development of contingency plans to address Year 2000 Issues that cannot be remediated. The timing for the fourth phase will depend upon the results of the second and third phases and, therefore, no schedule for the fourth phase can be set at this time. Since the Company is in the initial phases of its Year 2000 program, it is likewise currently unable to estimate the costs to remediate its Year 2000 Issues. The costs incurred to date have not been material and the Company does not expect the Year 2000 Issue to have a material impact on the Company's future operations or financial results.
Vendors that provide payroll, banking, communications and property management services to the Company and the Company's operators, lessees and borrowers will also likely be affected by the Year 2000 Issue. The future operations of the Company could be disrupted and/or its financial results could be negatively impacted by the Year 2000 Issue if the Company's vendors or its operators, lessees or borrowers do not adequately address their Year 2000 Issues. As health care providers, the Company's operators, lessees and borrowers generally rely extensively on information systems, including systems for capturing patient and cost information and for billing and collecting reimbursement for health care services provided. In addition, the delivery of patient care by providers requires utilization of critical clinical systems, medical devices and equipment that could be impacted by the year 2000 Issue. Furthermore, the Company's operators, lessees and borrowers likewise are dependent on a variety of third parties, including but not limited to, insurance companies, HMO's and other private payors, governmental agencies, fiscal intermediaries that process claims and make payments for the Medicare and Medicaid programs, utilities that provide electricity, water, natural gas and communications services and vendors of medical supplies, pharmaceuticals, clinical, systems, medical devices and equipment used in patient care, all of whom must also adequately address the Year 2000 Issue. The Company is reviewing publicly filed information of, sending questionnaires to and/or contacting its vendors, operators, lessees and borrowers regarding their state of readiness with respect to identifying and remediating their Year 2000 Issues. However, it is not possible for the Company to determine or be assured that adequate remediation of the Year 2000 Issue will be accomplished by such vendors, operators, lessees and borrowers. Furthermore, it is not possible for the Company to determine or be assured that third parties upon which the Company's vendors, operators, lessees and borrowers are dependent will accomplish adequate remediation of their Year 2000 Issues.
Although the Company believes that the impact of the Year 2000 Issue, as it relates to its internal information systems, office equipment and the embedded building control systems in its multi-tenant properties, will not be material, the Company cannot be assured that the Year 2000 Issues of its vendors or its operators, lessees and borrowers and the third parties upon which they are dependent will not have a material impact on the future operations and/or financial results of the Company.
LIQUIDITY AND CAPITAL RESOURCES
The Psychiatric Group likely will provide the operator of its Sunrise property with additional working capital loans of up to $700,000. At March 18, 1999, the Psychiatric Group had $3.8 million of inter-Group loans owed to it by the Core Group, $400,000 in cash and short-term investments and no inter-Group loans it owed to the Core Group. The Company's Board of Directors has established certain management policies relating to the Core Group's commitment to provide inter-Group loans to the Psychiatric Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the
Company's Board of Directors, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,865,000 at any one time outstanding, which limit is to be reduced dollar-for-dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no other inter-Group loans will be advanced to the Psychiatric Group by the Core Group. The Psychiatric Group has no third-party sources of additional financing and, as a result, is dependent on the Core Group for all such financing. Although the Core Group may make this financing available, there is no obligation of the Company's Board of Directors to cause the Core Group to provide funds to the Psychiatric Group if the Board of Directors determines that it is in the Company's best interest not to do so. To the extent needed funds are not advanced by the Core Group, the Psychiatric Group would experience immediate, significant negative effects.
The Psychiatric Group does not expect to make any additional acquisitions or capital investments. Future dividend payments will be determined quarterly and will be primarily dependent upon the financial performance of the Psychiatric Group. In general, the Psychiatric Group will not retain any significant amount of its cash flow, and as discussed above, its sources of financing and liquidity will be limited.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's consolidated balance sheets as of December 31, 1998 and 1997 and its consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 1998, 1997 and 1996, together with a report of Arthur Andersen LLP, independent public accountants, are included elsewhere herein. The Core Group's and the Psychiatric Group's combined balance sheets as of December 31, 1998 and 1997, and their combined statements of operations, total attributed equity and cash flows for the years ended December 31, 1998, 1997 and 1996, together with reports of Arthur Andersen LLP, independent public accountants, also are included elsewhere herein. See "Index to Financial Statements."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
There is hereby incorporated by reference the information to appear under the caption "Election of Directors" in the Company's proxy statement for its June 11, 1999 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1998. See "Item 1. Business -- Executive Officers of the Company" for a description of the Executive Officers of the Company.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION.
There is hereby incorporated by reference the information to appear under the caption "Compensation of Directors and Executive Officers" in the Company's proxy statement for its June 11, 1999 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1998.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
There is hereby incorporated by reference the information to appear under the caption "Principal Shareholders of the Company" in the Company's proxy statement for its June 11, 1999 Annual Meeting of Shareholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 1998.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
None.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES, AND REPORTS ON FORM 8-K.
(A)(1) AND (2) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES.
The financial statements and schedule listed in the accompanying index to the consolidated, Core Group combined and Psychiatric Group combined financial statements, are filed as part of this Annual Report on Form 10-K.
(A)(3) EXHIBITS.
- - --------------- * Filed herewith
(B) REPORTS ON FORM 8-K.
None.
AMERICAN HEALTH PROPERTIES, INC.
AND FINANCIAL STATEMENT SCHEDULE
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To American Health Properties, Inc.:
We have audited the accompanying consolidated balance sheets of American Health Properties, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of American Health Properties, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Denver, Colorado, January 22, 1999.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
THE COMPANY
American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities.
The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes. Attribution of the components of the Company's capital structure to its Core Group and Psychiatric Group for financial accounting and reporting purposes does not affect the legal title to assets or responsibility for liabilities of the Company, and each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to the risks associated with an investment in the Company and all of its businesses, assets and liabilities.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation. The accompanying consolidated financial statements include the accounts of the Company and all subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The financial statements of the Core Group and the Psychiatric Group also are included elsewhere herein.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Short-Term Investments. Cash and short-term investments consist of cash and all highly liquid investments with an original maturity date of less than three months and are stated at cost which approximates fair value.
Real Estate Properties. The Company records properties at cost and recognizes depreciation on a straight-line basis over the estimated useful lives of the buildings and improvements (21 to 42 years). Tenant improvements paid for by the Company are capitalized and depreciated over the lives of the related leases. In general, other capital expenditures incurred are capitalized when significant and depreciated over the period they are expected to provide benefits to the related property.
Impairment of Real Estate Properties and Notes Receivable. The Company reviews the carrying value of its real estate properties and notes receivable for possible impairment of value whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. In general, an impairment of such assets would be indicated if the estimated future cash flows expected to result from the use of such assets and their eventual disposition is less than their carrying amounts.
Additional Rental and Interest Income. Certain of the Company's facility leases provide for contingent rental or interest income based upon specific target revenues of the operator. The Company recognizes contingent rental and interest income on a quarterly basis by comparing the specific target to an estimate of
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
the operator's future operating revenues for the remainder of the lease calculation period. If the Company deferred recognition of contingent rental and interest income until the specific target that triggers the contingent rental or interest income was achieved, there would not have been a material impact on the Company's financial statements for the year ended December 31, 1998.
Deferred Income. Fees received, net of related direct costs, associated with the origination or amendment of leases and mortgage notes receivable are deferred and amortized at a constant effective rate over the remaining term of the related leases and mortgage notes receivable.
Deferred Costs. Deferred financing costs are amortized over the term of the related debt at a constant effective rate.
Federal Income Taxes. The Company intends at all times to operate so as to qualify as a REIT under Sections 856 to 860 of the Internal Revenue Code. As such, the Company generally will not be subject to federal income tax to the extent it distributes to shareholders at least 100% of its taxable income.
Qualification as a REIT under Sections 856 to 860 of the Internal Revenue Code applies to the Company as a whole, rather than the Core Group or Psychiatric Group individually. Dividends paid by the Company on its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares must be sufficient in the aggregate for the Company to meet the minimum distribution requirements of the Internal Revenue Code. The Company's earnings and profits as a whole, without reference to the Core Group or Psychiatric Group individually, is used to determine the taxable character of dividends paid to holders of its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares, with earnings and profits allocated first to Series B Depositary Shares.
Earnings and profits, which determine the taxable character of dividends paid to stockholders, differ from net income for financial reporting purposes due primarily to timing differences in the recognition of deferred income, impairment losses and various accruals and differences between the estimated useful lives used to compute depreciation for financial statement purposes and a 40-year life generally used in determining earnings and profits. The cost basis of the Company's real estate properties is generally the same for financial reporting and earnings and profits purposes, except for properties written down for financial reporting purposes and properties for which the previous owner's basis is required to be carried forward for tax purposes.
New Accounting Standards. In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Company's financial statements.
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Currently, the Company has two such reportable operating segments, the Core Group and the Psychiatric Group.
In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits, requires additional information on changes in the benefit obligations and fair values of plan assets and eliminates certain previous disclosures. The adoption of this statement in 1998 had no impact on the Company's financial statements.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption of this statement in 2000 is not expected to have a material impact on the Company's financial statements.
In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. The adoption of SOP 98-5 in 1998 had no impact on the Company's financial statements.
REAL ESTATE PROPERTIES
The following table summarizes the Company's investment in health care real estate properties as of December 31, 1998:
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
- - ---------------
(1) Casa Blanca Clinic represents four separate facilities leased together under a single master lease. Fannin Medical Buildings represent two separate facilities master-leased to affiliated tenants under separate leases, with one such facility encumbered by a $17,495 mortgage note payable. Emerson Medical Office Building/Surgery Center represents two separate facilities, one of which is master-leased and the other leased to multiple tenants.
(2) Murfreesboro Medical Clinic is encumbered by a $3,277 mortgage note payable.
A substantial portion of the Company's properties are leased to single-tenant operators under "net" leases pursuant to which the lessees are responsible for all maintenance, repairs, taxes and insurance of the leased properties. The leases provide for the payment of minimum base rent and additional rent during the fixed term
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
and any renewal terms. Additional rent is generally based on the increase in annual gross revenues of the related facility or the consumer price index as specified in the lease agreements. The Company has the right to approve capital expenditures at such properties, the option to fund certain capital expenditures and, in certain situations, is obligated to fund approved capital expenditures on terms comparable to the original investment. The base and additional rent provisions of the leases are amended when such capital expenditures are funded to reflect the Company's increased investment. At December 31, 1998, the Company had no commitments to fund capital expenditures pursuant to these rights and obligations.
Many of the Company's medical office/clinic facilities are leased to multiple tenants on a gross or modified net basis pursuant to which the Company, as lessor, is responsible for a portion of the operating costs of the building, including but not limited to the cost of maintenance, repairs, insurance and taxes on the leased properties. In general, the Company is also initially responsible for capital expenditures, leasing commissions and tenant improvements at these buildings, subject to reimbursement from tenants in some instances.
At December 31, 1998, the Company had construction in progress of $14,247,000. As of December 31, 1998, the Company had funded $5,230,000 of a $9.5 million commitment to develop a skilled nursing facility in Las Vegas, Nevada to be operated by an experienced operator of skilled nursing facilities. As of December 31, 1998, the Company had funded $8,329,000 of an $18.6 million commitment to develop three assisted living facilities to be managed by an experienced operator of assisted living facilities. The Company has a $22.5 million forward funding commitment to develop up to nine Alzheimer's care facilities to be managed by the same operator that currently manages two existing Alzheimer's care facilities owned by the Company. As of December 31, 1998, $688,000 was funded under this commitment for the development of one facility having a total development cost of approximately $2.8 million. The Company has identified a second facility site under this commitment having a total development cost of approximately $2.8 million. The Company also has a $5.7 million commitment to develop a medical office/clinic facility in Roseburg, Oregon to be master-leased to the operator of the adjacent hospital.
Six of the Company's acute care properties are leased to subsidiaries of American Medical International, Inc. (AMI), a subsidiary of Tenet Healthcare Corporation. The six leases are covered by cross-default provisions and the lease obligations are unconditionally guaranteed by AMI. In 1998, revenues from these leases accounted for 41% of the Company's total revenues.
Kendall Regional Medical Center (Kendall) is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). Aggregate revenues from the lease, which was originally scheduled to mature in February 1999, were approximately $10.3 million in 1998, or 9% of the Company's total revenues. Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at fair market value. The purchase price of $105 million will be paid in cash, or at the option of the Company, a combination of cash and debt relief. The Company currently intends to effect the transaction as a "deferred like-kind" 1031 exchange for tax purposes. The first part of the exchange, the transfer of Kendall to Columbia, is currently scheduled to occur on April 15, 1999. The Company would complete the exchange by acquiring new investment properties within the time limits imposed by federal tax law, if possible. If the Company is successful in identifying and closing on a sufficient amount of new investments within the required time limits, the Company should not recognize current taxable gain as a result of the transaction. In that event, there should be no impact on the Company's REIT distribution requirements. Even though the Company may not recognize gain on the transaction for tax purposes, the Company expects to be able to recognize a gain of over $50 million for book purposes. The Company cannot be assured that total revenues generated by new investments acquired to effect the exchange will equal the annual revenues currently generated by the Kendall investment, nor is it certain that the Company will complete the transaction as an exchange. If the Company does not complete the transaction as an exchange, the amount of the Company's tax liability, the impact on its REIT distribution requirements and the amount of gain, net of taxes, if any, recognized for book purposes
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
would depend on the amount of gain recognized for tax purposes, any losses recognized by the Company on sales of other assets and various tax elections available to the Company.
Future minimum annual rentals, assuming the sale of Kendall on April 15, 1999, under the Company's noncancellable operating leases for calendar years 1999 through 2003 are approximately $89,360,000, $85,670,000, $80,640,000, $75,490,000, and $73,690,000, respectively.
The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in the periodic restructuring of psychiatric operator payment obligations, the closing of one psychiatric hospital and significant impairment losses on psychiatric investments, including an $11 million charge in 1997 and a $8.3 million charge in 1998. At December 31, 1998, the aggregate carrying value of the Company's psychiatric properties was $5,131,000. The Northpointe property has been vacant since mid-1997 and has a carrying value of $1,300,000. The Company incurs ongoing costs for maintenance and security of the property while it continues to seek alternate uses or a buyer for the property. The operator of the Rock Creek Center (RCC) experienced continuing financial and operational difficulties over the past several years, and at the end of 1998, the operator was in default on its obligations to the Company. As a result, the carrying value of the RCC property was written down to $1,200,000 and the Company's net investment in related notes and various other obligations owed to it by the operator of RCC were totally written off. Subsequent to year-end, the Company sold its total RCC investment for a cash price of $2.5 million. At December 31, 1998, the Sunrise Regional Medical Center (Sunrise) property had a carrying value of $2,631,000. In September 1998, a new operator assumed all operational responsibility for the hospital and entered into a new five-year lease with effective monthly rent of $60,000. Although the new operator has fulfilled its obligations to the Company under the lease so far, the new operator has experienced cash flow difficulties primarily as a result of delays in obtaining Baker Act certification. As a result, the Company provided the operator with a $200,000 working capital loan at the end of 1998, and subsequent to year-end, the operator requested $700,000 of additional working capital loans. Although this request is still being evaluated, the Company likely will provide the additional loans. The Company cannot be assured that the operator will be successful and, if it were to cease operations, an impairment charge to reduce the carrying value of the Sunrise property and any related outstanding working capital loans would be likely. The Company will continue to encourage the operator to pursue financing alternatives that might enable it to acquire the property and repay its borrowings from the Company.
MORTGAGE NOTES RECEIVABLE
SCCI Hospital -- Houston Central $4,400,000. The Company has a mortgage note receivable secured by a first mortgage and security interest in the real property of a long-term acute care facility in Houston, Texas. The note has an initial term of ten years with two optional ten-year extension terms. The initial term maturity date is June 30, 2007. The interest rate on the note is 10.50% with interest only payable monthly through June 30, 1999 and monthly principal and interest payments of $40,000 payable thereafter. Pursuant to the terms of the mortgage note receivable, the Company may receive additional interest each year based on the increase in annual operating revenues of the facility.
Four Winds. The Company had two mortgage notes receivable secured by first mortgages and security interests in the real property of Four Winds, two psychiatric facilities located in Saratoga Springs and Katonah, New York. The Saratoga Springs note had an initial term of ten years with a maturity date of June 30, 1999, bore interest at a rate of 12.42% and required monthly principal and interest payments of $194,000. The Katonah note had an initial term of ten years with a maturity date of November 30, 2002, bore interest at rates of 13.44%, 13.80% and 14.13%, in 1996, 1997 and 1998, respectively and required monthly payments of interest only. On July 1, 1998, the Company received $35 million as prepayment in full of the two Four Winds mortgage notes receivable resulting in an impairment loss of $2.73 million.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The carrying amount of mortgage notes receivable is a reasonable estimate of fair value, as the pricing and terms of the notes are indicative of current rates and credit risk.
OTHER NOTES RECEIVABLE
In 1998, the Company committed to advance funds on a senior subordinated note due from the operator of an Alzheimer's care facility for a total maximum principal amount of $1,902,000. The note is secured by a pledge of stock in the operator and is personally guaranteed by one of its principals. Advances under the note are conditioned upon borrower's compliance with various covenants. The Company has no obligation to make principal advances after February 27, 2003. As of December 31, 1998, $1,468,000 was outstanding under the note, which included principal advanced of $1,283,000 and accrued interest of $185,000. Prior to December 31, 2002, interest accrues on the principal balance of the note at a rate of 18% per annum and will be added to the outstanding principal balance on a quarterly basis. Accrued interest is payable quarterly as it accrues commencing January 1, 2003 until March 31, 2006, subject to an intercreditor agreement and certain earnings requirements of the operator. Commencing April 1, 2006, quarterly principal and interest payments sufficient to amortize the principal amount of the loan as of March 31, 2006 together with unpaid interest are due in equal quarterly installments until April 1, 2012 at which time all unpaid principal and interest amounts are due and payable.
The Company has provided financing at variable rates to certain psychiatric hospital operators under revolving credit agreements and working capital loans. Borrowings under these agreements are conditioned upon the borrower's compliance with various covenants and are partially secured by accounts receivable, other personal property and/or issued and outstanding shares of capital stock of the operators. As of December 31, 1998, $195,000 was outstanding under a $200,000 working capital loan provided to one psychiatric hospital operator at an annual interest rate of 12%. Interest only on the note is payable monthly through August 1, 1999. Commencing September 1, 1999, principal and interest payments of $35,000 are payable monthly until maturity on February 1, 2000. During 1998, $2,485,000 of outstanding borrowings were written off by the Company as part of a $5.6 million impairment loss recorded on psychiatric investments, and during 1997, $1,724,000 of outstanding borrowings were written off as part of an $11.0 million impairment loss recorded on psychiatric investments.
The pricing and terms of other notes receivable are indicative of current rates and credit risk, and therefore, the current carrying amount of these financial instruments is a reasonable estimate of fair value.
DIRECT FINANCING LEASES
In connection with its investments in certain acute and long-term care properties, the Company has provided equipment leasing for terms of five to seven years which are classified as direct financing leases. As of December 31, 1998, the Company's aggregate net investment in these direct financing leases was $1,975,000, represented by total minimum lease payments receivable of $2,163,000 less unearned income of $188,000. Future minimum annual lease payments under these leases for calendar years 1999 through 2002 are approximately $1,342,000, $704,000, $94,000 and $23,000, respectively.
DEBT
Bank Loans Payable. The Company has a $250 million unsecured revolving credit agreement with a syndicate of banks that matures on December 31, 2000 and bears an annual facility fee based on the total commitment. This agreement provides for interest on outstanding borrowings based on, at the Company's election, LIBOR plus a margin, a rate bid by the lenders, or the prime rate. The margin on LIBOR borrowings and the annual facility fee may vary and are dependent upon various conditions, including the Company's debt ratings and the level of borrowings outstanding. Currently, the Company's LIBOR margin is 62.5 basis points and the annual facility fee is 25 basis points.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The weighted average amount of borrowings under bank credit agreements outstanding during 1998, 1997 and 1996 was $37,764,000, $6,151,000 and $21,622,000 at weighted average interest rates of 6.3%, 7.1%, and 6.4%, respectively. The maximum amount outstanding under bank credit agreements in 1998, 1997 and 1996 was $75,000,000, $48,500,000 and $53,000,000, respectively. As of December 31, 1998, the Company had $69,000,000 of outstanding borrowings under its bank credit agreement at a weighted average interest rate of 6.0%.
The duration of borrowings under the Company's unsecured revolving credit agreement is generally less than 90 days at variable pricing indicative of current short-term borrowing rates. Accordingly, the carrying amount is a reasonable estimate of fair value.
Mortgage Notes Payable. In connection with the acquisition of a medical office building in Houston, Texas in 1997, a mortgage note payable in the amount of $17,956,000 was assumed. The remaining balance at December 31, 1998 and 1997 was $17,495,000 and $17,922,000, respectively with an interest rate of 8.30%. The note is secured by a first mortgage and security interest in the real property and requires a monthly payment of principal and interest of approximately $158,000 with the remaining principal balance due at maturity on June 15, 2011.
In connection with the acquisition of a medical office building in Murfreesboro, Tennessee in 1998, a mortgage note payable in the amount of $3,375,000 was assumed. The remaining balance at December 31, 1998 was $3,277,000 with an interest rate of 7.0%. The note is secured by a first mortgage and security interest in the real property and requires a monthly payment of principal and interest of approximately $33,000 with the remaining principal balance due at maturity on October 2, 1999.
The carrying amount of the mortgage notes payable is a reasonable estimate of fair value, as the pricing and terms of the notes are indicative of current rates and credit terms.
Senior Notes Payable. In January 1997, the Company completed a $220 million public debt offering of unsecured senior notes payable, issuing $100 million of notes with a coupon rate of 7.05% due January 15, 2002 (2002 Notes) and $120 million of notes with a coupon rate of 7.50% due January 15, 2007 (2007 Notes). The 2002 Notes and 2007 Notes have effective interest rates of approximately 7.34% and 7.74%, respectively. Interest is payable at the coupon rates semi-annually on January 15th and July 15th.
The fair value of the Company's 2002 Notes and 2007 Notes is based on the quoted market price of the notes as traded over-the-counter. As of December 31, 1998 and 1997, the estimated fair value of the 2002 Notes and 2007 Notes was $208 million and $225 million, respectively.
In February 1997, the Company prepaid its two issues of private placement debt, which included $72 million of 11.45% unsecured senior notes payable and $80 million of 10.41% unsecured senior notes payable. The weighted average amount of borrowings under these senior note issues during 1997 and 1996 was $22,800,000 and $178,250,000 at weighted average effective interest rates of 11.06% and 11.03%, respectively. The prepayment resulted in an extraordinary charge in the first quarter of 1997 of $11,427,000 consisting of a make-whole premium and other costs related to the prepayment.
Subordinated Convertible Bonds Payable. The Company's Convertible Dual Currency Subordinated Bonds (the Swiss Bonds) were sold in Switzerland pursuant to public subscription in 1990. The Swiss Bonds had a coupon rate of 8.5% and were convertible at the option of the holder at any time until July 9, 2000 into shares of the Company's common stock at a conversion price of $23.45 per share and a fixed exchange rate of Sfr. 1.41 per U.S. $1.00. In 1998, $10,000 of the 1990 Swiss Bonds, with accrued interest, were converted into 302 shares of common stock resulting in additional equity of $10,000, net of conversion and unamortized issuance costs. There were no conversions of Swiss Bonds in 1997 or 1996. Pursuant to the Company's call for early redemption, the remaining 1,489 outstanding Swiss Bonds were redeemed on December 30, 1998 for
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
approximately $7,058,000. As of December 31, 1997, the estimated fair value of the Company's subordinated convertible bonds payable was $7,259,000 based on the quoted market price of bonds as traded in Switzerland.
Debt Covenants. Covenants and restrictions in the Company's various debt agreements include limitations on secured borrowings, restrictions covering the use of proceeds from asset sales and payments of dividends and requirements relating to the maintenance of specified financial covenants, including those relating to minimum tangible net worth, fixed charge coverage and ratios of liabilities to minimum tangible net worth and asset values.
Annual Maturities. The aggregate amount of annual maturities of the Company's outstanding debt at December 31, 1998, for calendar years 1999 through 2003 and thereafter is $3,741,000, $504,000, $547,000, $100,594,000, $646,000 and $134,740,000, respectively. In addition, the outstanding balance of $69,000,000 at December 31, 1998 under the Company's unsecured revolving credit agreement matures on December 31, 2000, although certain events could require the earlier paydown of the outstanding balance.
Interest. Interest capitalized on construction in progress was $819,000, $517,000 and $895,000 in 1998, 1997 and 1996, respectively. Interest paid, net of interest capitalized, in 1998, 1997 and 1996 was $20,482,000, $14,374,000 and $21,547,000, respectively.
PENSION PLANS
The Company has a defined contribution pension plan covering all of its employees. Pension expense in 1998, 1997 and 1996 was $287,000, $207,000 and $247,000, respectively.
The Company has an unfunded defined benefit pension plan covering non-employee members of its Board of Directors elected prior to 1997 upon completion of sixty months of membership on the Board. The benefits, limited to ten years, are based on years of service and the annual base director fee in effect as of the date a director ceases to be a member of the Board.
The following tables set forth the amounts recognized in the Company's financial statements:
Change in benefit obligations:
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Components of net pension cost:
Discount rates of 6.75% and 7.0% for 1998 and 1997, respectively, and a 10.0% increase in annual base director fees once every five years were used in determining the actuarial present value of the projected benefit obligation. The discount rates used in determining the net pension cost for 1998, 1997 and 1996 were 7.0%, 7.5% and 7.0%, respectively.
STOCK INCENTIVE PLANS
The Company's stock incentive plans provide for the issuance of up to 2,600,000 shares of stock to directors and key employees of the Company. There were 726,114 shares available to grant further stock incentives at December 31, 1998.
The following is a summary of stock incentives activity:
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The following is a summary of significant ranges of outstanding and exercisable options at December 31, 1998:
Restrictions on shares of restricted stock lapse annually over a period of years. Expense is determined based on the market value at the date of award and is recognized over the period such restrictions lapse.
The exercise price of stock options is equal to the fair market value of the shares on the dates the options were granted. Stock options granted to directors become exercisable immediately or over two years and stock options granted to key employees become exercisable over two to four years. Stock options terminate ten years from the date of grant. Options on 661,247, 708,884 and 629,579 shares of Core Group Common Stock were exercisable at December 31, 1998, 1997 and 1996 with weighted average exercise prices of $23.07, $22.55 and $22.90 per share, respectively. Options on 45,444, 61,557 and 64,210 Psychiatric Group Depositary Shares were exercisable at December 31, 1998, 1997 and 1996 with weighted average exercise prices of $22.16, $22.07 and $22.75 per share, respectively.
DERs have been granted in tandem with some of the stock options granted to key employees. At each dividend declaration date, a calculation is made to determine the number of shares that could be acquired if dividends were paid on shares under option for a period of up to five years from the date of grant and on accumulated DER shares for a period of up to ten years from the date of grant, and such number of shares are accumulated for the benefit of option holders over the term of the option grant. Upon exercise or expiration of the related option, each option holder is entitled to receive additional shares equivalent to the accumulated number of related DER shares. Expense related to the DER shares is equal to the equivalent amount of dividends used to determine the number of DER shares. Directors may elect to receive payment of their annual Board fees on a deferred basis in the form of stock of the Company. These deferred shares, and related accumulated DER shares, are issued to the director making such an election at the end of each three-year deferral period. At December 31, 1998, substantially all deferred and DER shares were issuable upon exercise of the related vested options or otherwise unrestricted.
As allowed by SFAS 123, "Accounting for Stock-Based Compensation", the Company measures employee stock-based compensation expense using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees". Total stock-based compensation expense recognized under APB 25 in 1998, 1997 and 1996 was $1,334,000, $1,427,000 and $1,251,000 respectively.
As determined under SFAS 123, the weighted average fair value at the date of grant for options to purchase Core Group Common Stock granted during 1998, 1997 and 1996 was $5.57, $5.11 and $4.84 per
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
option, respectively. The fair value of options was estimated using an option pricing model with the following weighted average assumptions:
The weighted average fair value at the date of grant for restricted and deferred shares of Core Group Common Stock granted during 1998, 1997 and 1996 was $25.44, $24.39 and $22.53 per share, respectively.
If the fair value based method of accounting defined by SFAS 123 had been used to measure and recognize stock-based compensation expense, the pro forma effect on the reported amounts of earnings per share of the consolidated Company, the Core Group and the Psychiatric Group for 1998, 1997 and 1996 would not have been material. The pro forma effect for 1998, 1997 and 1996 may not be representative of the pro forma effect in future years because it does not take into consideration stock-based incentives granted prior to 1995.
STOCKHOLDERS' EQUITY
8.6% Cumulative Redeemable Preferred Stock, Series B. The Company has 4,000,000 Series B Depositary Shares outstanding which represent 40,000 shares of Series B Preferred Stock. Each Series B Depositary Share represents 1/100 of a share of Series B Preferred Stock, and entitles the holder to such proportion of all the rights, preferences and privileges of the Series B Preferred Stock represented thereby. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock, its Series A Preferred Stock (when and if issued) and its Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights. The annual dividend rate and liquidation preference with respect to each Series B Depositary Share are $2.15 and $25, respectively (equivalent to $215 and $2,500 per share of Series B Preferred Stock, respectively). Dividends on the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are cumulative and, if and when declared, are payable quarterly in arrears on the last day of February, May, August and November of each year. On or after October 27, 2002, the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, may be redeemed, in whole or in part, at the option of the Company at a redemption price of $25 per Series B Depositary Share (equivalent to $2,500 per share of Series B Preferred Stock), plus accrued and unpaid dividends thereon. The redemption price, other than the portion representing accrued and unpaid dividends, is payable solely out of proceeds from the sale of other capital stock of the Company. The proceeds from the sale of the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, as well as the dividends payable thereon, have been attributed to the Company's Core Group for financial accounting and reporting purposes.
Preferred Stock Purchase Rights Plan. On April 20, 1990, the Company distributed to shareholders one preferred stock purchase right (each a Right) for each outstanding share of common stock. Under certain conditions, each Right may be exercised to purchase 1/100 of a share of preferred stock, Series A, par value $.01 per share (the Series A Preferred Shares), of the Company at a price of $45. The Company's Psychiatric Group Depositary Shares do not include the Rights or entitle holders thereof to receive the Rights, which are applicable only to the Company's Core Group Common Stock. The total number of Rights currently issued or issuable, including Rights issuable in connection with common stock which may be issued under the Company's stock incentive plans is approximately 26,742,000. Approximately 267,000 Series A Preferred
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Shares could be purchased upon the exercise of all Rights currently issued or issuable. The number of Rights outstanding and Series A Preferred Shares issuable upon exercise, as well as the Series A Preferred Share purchase price, are subject to customary antidilution adjustments.
The Rights are evidenced by the certificates for shares of common stock, and in general are not transferable apart from the common stock or exercisable until after a party has acquired beneficial ownership of, or made a tender offer for, 10% or more of the outstanding common stock of the Company (an Acquiring Person), or the occurrence of other events as specified in the Rights Plan. Under certain conditions as specified in the Rights Plan, including but not limited to the acquisition by a party of 15% or more of the outstanding common stock of the Company or the acquisition of the Company in a merger or other business combination, each holder of a Right (other than an Acquiring Person whose Rights will be void) will receive upon exercise thereof and payment of the exercise price that number of shares of common stock of the Company or of the other party, as applicable, having a market value of two times the exercise price of the Right.
The Rights expire on April 20, 2000, and until exercised, the holder thereof, as such, will have no rights as a shareholder of the Company. At the Company's option, the Rights may be redeemed in whole at a price of $.01 per Right at any time prior to becoming exercisable. In general, the Company also may exchange the Rights at a ratio of one share of common stock per Right after becoming exercisable but prior to the acquisition of 50% or more of the outstanding shares of common stock by any party.
Series A Preferred Shares issuable upon exercise of the Rights will not be redeemable. Each Series A Preferred Share will have 100 votes and will be entitled to (a) dividends in an amount equal to the greater of $1.00 or 100 times the amount of the dividends per share paid on the common stock, (b) a liquidation preference in an amount equal to the greater of $100 or 100 times the amount per share paid on the common stock and (c) a payment in connection with a business combination (in which shares of common stock are exchanged) equal to 100 times the amount per share paid on the common stock. The Series A Preferred Stock (when and if issued) rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights, but rank junior to the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
EARNINGS PER SHARE
The following is a reconciliation of the income and share amounts used in the basic and diluted per share computations of income before extraordinary item attributable to Core Group Common Stock and Psychiatric Group Depositary Shares:
DIVIDENDS AND REDEMPTION PROVISIONS
A quarterly dividend of $.565 per share for Core Group Common Stock, or approximately $14,116,000, was declared by the Board of Directors on January 22, 1999, payable on February 24, 1999 to shareholders of record on February 10, 1999. A quarterly dividend of $.095 per share for Psychiatric Group Depositary Shares, or approximately $198,000, was declared by the Board of Directors on January 22, 1999, payable on February 24, 1999 to shareholders of record on February 10, 1999. A dividend of $.5375 per share for Series B Depositary Shares was declared by the Board of Directors on January 22, 1999, payable March 1, 1999 to shareholders of record February 15, 1999. This dividend was for the regular quarterly period ended February 28, 1999 of which approximately $717,000 was accrued at December 31, 1998. The aggregate dividends of $15,031,000 have been reflected as dividends payable in the accompanying financial statements as of December 31, 1998.
As a result of the payoff of the Four Winds mortgage notes receivable, the Company distributed 833,067 new shares of Core Group Common Stock at a price of $25.9407 per share to holders of Psychiatric Group Depositary Shares as a special stock dividend on July 24, 1998. Holders of Psychiatric Group Depositary Shares received 0.4 shares of Core Group Common Stock for each Psychiatric Group Depositary Share held and cash-in-lieu of fractional shares of Core Group Common Stock based on the price of $25.9407.
Cash dividends of $2.18 per share paid on Core Group Common Stock during 1998 are characterized as $1.076 of ordinary income and $1.104 of return of capital for tax purposes. Dividends of $12.62628 per share, including $2.25 of cash dividends and a special stock dividend valued at $10.37628, paid on Psychiatric Group
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Depositary Shares during 1998 are characterized as $6.2325 of ordinary income and $6.39378 of return of capital for tax purposes. For Psychiatric Group Depositary Share holders of record on July 17, 1998, the initial tax basis in the Core Group Common Stock distributed as a special stock dividend is $25.9407 per share of Core Group Common Stock. Cash dividends of $2.15 per share paid on Series B Depositary Shares during 1998 are characterized entirely as ordinary income for income tax purposes.
In general, cash dividends on the Company's Core Group Common Stock and Psychiatric Group Depositary Shares are limited by the Company's unsecured revolving credit agreement to 95% of cash flow available for debt service, less interest expense, plus gains on asset dispositions and certain proceeds from the disposition of Psychiatric Group assets.
Dividends on the Company's Psychiatric Group Depositary Shares are determined each quarter based upon the operating results of the Company's Psychiatric Group. It continues to be the policy of the Board to maintain a dividend payout ratio for each quarter in excess of 90 percent of the Psychiatric Group's funds from operations for the related quarter, when possible. With the disposition of the RCC investment subsequent to year-end, the Sunrise investment is currently the sole income-producing property of the Company's Psychiatric Group and the operator of Sunrise is experiencing cash flow difficulties. Therefore, commencing in the second quarter of 1999, the Psychiatric Group's funds from operations may not be sufficient to permit the payment of a dividend on the Psychiatric Group Depositary Shares.
The Company intends to periodically evaluate the financial position of the Psychiatric Group, including an assessment of the potential cash requirements of the Psychiatric Group and the appropriate use of the proceeds from the sale of the RCC investment. Initially, proceeds from the RCC disposition, net of closing costs and applicable reserves, will be retained by the Psychiatric Group to defray its ongoing costs, including the potential long-term costs of carrying the two remaining Psychiatric Group properties. The Psychiatric Group may continue to retain such proceeds or, alternatively, may distribute a portion of such net proceeds to holders of Psychiatric Group Depositary Shares, in cash or Core Group Common Stock, either by dividend or in connection with redemption of the Psychiatric Group Depositary Shares. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may elect to redeem the outstanding Psychiatric Group Depositary Shares in cash or in exchange for shares of Core Group Common Stock. Under the terms of the Certificate of Designations for the Psychiatric Group Preferred Stock and the Deposit Agreement providing for issuance of Depositary Receipts (Psychiatric Group Depositary Shares) each representing one-tenth of one share of the Psychiatric Group Preferred Stock, the Company has the right to redeem all outstanding Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, for cash (or in exchange for newly issued shares of Core Group Common Stock) at a premium generally ranging from 5% to 15% over the value of the Psychiatric Group Depositary Shares. Since an exchange or redemption of the Psychiatric Group Depositary Shares may be at a premium to the then current market price of the Psychiatric Group Depositary Shares, and since the Board could determine to effect such an exchange or redemption at a time when either or both the Core Group Common Stock and the Psychiatric Group Depositary Shares may be considered to be overvalued or undervalued, the exchange or redemption could be disadvantageous to the holders of the Core Group Common Stock or the Psychiatric Group Depositary Shares.
SEGMENT INFORMATION
The Company has two reportable operating segments, the Core Group and the Psychiatric Group, for which separate financial information is available and whose operating results are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Operating results of the Core Group reflect the separate financial performance of a distinct portfolio of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities. Operating results of the Psychiatric Group reflect the
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
separate financial performance of a distinct portfolio of the Company's investments in psychiatric hospitals. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before depreciation and amortization and impairment losses on real estate and notes receivable. The reportable segments are business units of the Company that are managed separately based on the two distinct portfolios, with two distinct classes of publicly-traded shares intended to represent those portfolios. The following table summarizes pertinent financial information of the Company's reportable operating segments:
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(1) The difference between total segment revenues and total consolidated revenues, represents interest income on inter-Group loans of $829, $1,553 and $1,679 in 1998, 1997 and 1996, respectively.
(2) The difference between total segment assets and total consolidated assets, represents inter-Group loans of $180, $12,554 and $13,358 for 1998, 1997 and 1996, respectively.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
QUARTERLY FINANCIAL DATA (UNAUDITED)
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(1) Includes impairment loss of $2,730 on Psychiatric Group notes receivable.
(2) Includes impairment loss of $5,600 on Psychiatric Group real estate and notes receivable.
(3) Includes impairment loss of $11,000 on Psychiatric Group real estate and notes receivable.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULE
We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in this Annual Report on Form 10-K, and have issued our report thereon dated January 22, 1999. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index of financial statements is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Denver, Colorado, January 22, 1999.
SCHEDULE III -- REAL ESTATE AND ACCUMULATED DEPRECIATION
AMERICAN HEALTH PROPERTIES, INC. DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
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(a) The cost basis of the properties for Federal income tax purposes is the same as the gross carrying amount; except for those properties for which an impairment loss was recorded in 1994, 1997 and 1998, the property in Cheraw, South Carolina for which the previous owner's basis of $3.7 million is required to be carried forward and the property in Murfreesboro, Tennessee for which the previous owner's basis of $10.1 million is required to be carried forward.
(b) Most properties have had improvements since their initial construction. The range of dates reflects the construction date of the original structures through the latest date of improvements.
(c) This property was conveyed to the Company in December 1992 in connection with the restructuring and forgiveness of a mortgage note receivable. The $21.4 million mortgage note receivable had been written down in June 1992 to $10 million. Subsequent recovery of a $1.1 million interest reserve fund from the mortgagee reduced the Company's recorded investment in the note to $8.8 million (net of unamortized fees) which became the Company's basis in the property upon its conveyance. The property was subsequently written down by $2.3 million, net in 1994 and $3.8 million, net in 1998.
(d) This property was written down by $6.6 million, net in 1994, $5.9 million, net in 1997.
(e) This property was written down by $3.4 million, net in 1997 and $500,000, net in 1998.
(f) As applicable, the gross carrying amount at December 31, 1998 of buildings and improvements includes the cost of tenant improvements.
SCHEDULE III -- REAL ESTATE AND ACCUMULATED DEPRECIATION -- (CONTINUED)
AMERICAN HEALTH PROPERTIES, INC. DECEMBER 31, 1998 (DOLLARS IN THOUSANDS)
SUMMARY OF REAL ESTATE AND ACCUMULATED DEPRECIATION ACTIVITY:
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To American Health Properties, Inc.:
We have audited the accompanying combined balance sheets of the Core Group (a business unit of American Health Properties, Inc.) as of December 31, 1998 and 1997, and the related combined statements of operations, total attributed equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the management of American Health Properties, Inc. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Core Group as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Denver, Colorado, January 22, 1999.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CORE GROUP COMBINED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CORE GROUP COMBINED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CORE GROUP COMBINED STATEMENTS OF TOTAL ATTRIBUTED EQUITY
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
CORE GROUP COMBINED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS
THE COMPANY
American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities.
The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation. The financial statements of the Core Group include the financial position, results of operations and cash flows of the Company's core investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities, an allocated portion of the Company's general and administrative expense, all corporate assets and liabilities and related transactions associated with the ongoing operations of the Company which are not separately identified with either operating Group, an attributed amount of inter-Group loans and an attributed amount of the Company's stockholders' equity. The Core Group financial statements are prepared using the amounts included in the Company's consolidated financial statements.
Although the financial statements of the Core Group and the Psychiatric Group separately report the assets, liabilities (including contingent liabilities), stockholders' equity and items of income, expense and cash flow of the Company attributed to each such Group, such attribution does not affect the legal title to assets or responsibility for liabilities of the Company or any of its subsidiaries. Furthermore, such attribution does not affect the rights of creditors of the Company or any subsidiary, including rights under financing covenants.
Each holder of Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to risks associated with an investment in the Company and all of its businesses, assets and liabilities. Financial effects arising from one Group that affect the Company's consolidated results of operations, financial condition, cash flows or borrowing costs may also affect the results of operations, financial condition, cash flows or borrowing costs of the other Group. In addition, net losses of either Group, as well as dividends and distributions on, and repurchases or redemptions of, Core Group Common Stock, Series B Depositary Shares or Psychiatric Group Depositary Shares will reduce the funds of the Company legally available for dividends on Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares. Accordingly, the Core Group's financial statements should be read in conjunction with the Company's consolidated financial statements and the financial statements of the Psychiatric Group.
These financial statements include the accounts of the Core Group business. The Core Group and the Psychiatric Group financial statements, taken together, comprise all of the accounts included in the Company's consolidated financial statements.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Short-Term Investments. Cash and short-term investments consist of cash and all highly liquid investments with an original maturity date of less than three months and are stated at cost which approximates fair value.
Real Estate Properties. The Core Group records properties at cost and recognizes depreciation on a straight-line basis over the estimated useful lives of the buildings and improvements (27 to 42 years). Tenant improvements paid for by the Core Group are capitalized and depreciated over the lives of the related leases. In general, other capital expenditures incurred are capitalized when significant and depreciated over the period they are expected to provide benefits to the related property.
Impairment of Real Estate Properties and Notes Receivable. The Core Group reviews the carrying value of its real estate properties and notes receivable for the possible impairment of value whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. In general, an impairment of such assets would be indicated if the estimated future cash flows expected to result from the use of such assets and their eventual disposition is less than their carrying amounts.
Additional Rental and Interest Income. Certain of the Core Group's facility leases provide for contingent rental or interest income based upon specific target revenues of the operator. The Core Group recognizes contingent rental and interest income on a quarterly basis by comparing the specific target to an estimate of the operator's future operating revenues for the remainder of the lease calculation period. If the Core Group deferred recognition of contingent rental and interest income until the specific target that triggers the contingent rental or interest income was achieved, there would not have been a material impact on the Core Group's financial statements for the year ended December 31, 1998.
Deferred Income. Fees received, net of related direct costs, associated with the origination or amendment of leases and mortgage notes receivable are deferred and amortized at a constant effective rate over the remaining term of the related leases and mortgage notes receivable.
Deferred Costs. Deferred financing costs are amortized over the term of the related debt at a constant effective rate.
Federal Income Taxes. The Company intends at all times to operate so as to qualify as a REIT under Sections 856 to 860 of the Internal Revenue Code. As such, the Company generally will not be subject to federal income tax to the extent it distributes to shareholders at least 100% of its taxable income.
Qualification as a REIT under Sections 856 to 860 of the Internal Revenue Code applies to the Company as a whole, rather than the Core Group or Psychiatric Group individually. Dividends paid by the Company on its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares must be sufficient in the aggregate for the Company to meet the minimum distribution requirements of the Internal Revenue Code. The Company's earnings and profits as a whole, without reference to the Core Group or Psychiatric Group individually, is used to determine the taxable character of dividends paid to holders of its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares, with earnings and profits allocated first to Series B Depositary Shares.
Earnings and profits, which determine the taxable character of dividends paid to stockholders, differ from net income for financial reporting purposes due primarily to timing differences in the recognition of deferred income, impairment losses and various accruals and differences between the estimated useful lives used to compute depreciation for financial statement purposes and a 40-year life generally used in determining earnings and profits. The cost basis of the Company's real estate properties is generally the same for financial reporting and earnings and profits purposes, except for properties written down for financial reporting purposes and properties for which the previous owner's basis is required to be carried forward for tax purposes.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
New Accounting Standards. In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Core Group's financial statements.
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Core Group is a separate operating segment of the Company and does not have separate reportable operating segments.
In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits, requires additional information on changes in the benefit obligations and fair values of plan assets and eliminates certain previous disclosures. The adoption of this statement in 1998 had no impact on the Core Group's financial statements.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption of this statement in 2000 is not expected to have a material impact on the Core Group's financial statements.
In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. The adoption of SOP 98-5 in 1998 had no impact on the Core Group's financial statements.
CORPORATE ACTIVITIES, INTER-GROUP LOANS, THIRD-PARTY DEBT AND EQUITY
Financial Activities. As a matter of policy, the Company manages all financial activities on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance and repayment of all short-term and long-term debt; and the issuance of common and preferred stock. These activities are then attributed to the Core Group and the Psychiatric Group in the manner described herein.
Third-Party Debt. All of the Company's third-party debt ($308,936,000 and $243,813,000 at December 31, 1998 and 1997, respectively) has been attributed to the Core Group; however, the Core Group, together with the Psychiatric Group, is subject to all of the terms, restrictions and covenants relating to such third-party debt. This debt and its relevant terms are summarized in the following paragraphs.
Bank loans payable. The Company has a $250 million unsecured revolving credit agreement with a syndicate of banks that matures on December 31, 2000 and bears an annual facility fee based on the total commitment. This agreement provides for interest on outstanding borrowings based on, at the Company's election, LIBOR plus a margin, a rate bid by the lenders, or the prime rate. The margin on LIBOR borrowings and the annual facility fee may vary and are dependent upon various conditions, including the Company's debt ratings and the level of borrowings outstanding. Currently, the Company's LIBOR margin is 62.5 basis points and the annual facility fee is 25 basis points.
The weighted average amount of borrowings under bank credit agreements outstanding during 1998, 1997 and 1996 was $37,764,000, $6,151,000 and $21,622,000 at weighted average interest rates of 6.3%, 7.1% and 6.4%, respectively. The maximum amount outstanding under bank credit agreements in 1998, 1997 and 1996 was $75,000,000, $48,500,000 and $53,000,000, respectively. As of December 31, 1998, the Company had
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
$69,000,000 of outstanding borrowings under its bank credit agreement at a weighted average interest rate of 6.0%.
The duration of borrowings under the Company's unsecured revolving credit agreement is generally less than 90 days at variable pricing indicative of current short-term borrowing rates. Accordingly, the carrying amount is a reasonable estimate of fair value.
Mortgage notes payable. In connection with the acquisition of a medical office building in Houston, Texas in 1997, a mortgage note payable in the amount of $17,956,000 was assumed. The remaining balance at December 31, 1998 and 1997 was $17,495,000 and $17,922,000, respectively with an interest rate of 8.30%. The note is secured by a first mortgage and security interest in the real property and requires a monthly payment of principal and interest of approximately $158,000 with the remaining principal balance due at maturity on June 15, 2011.
In connection with the acquisition of a medical office building in Murfreesboro, Tennessee in 1998, a mortgage note payable in the amount of $3,375,000 was assumed. The remaining balance at December 31, 1998 was $3,277,000 with an interest rate of 7.0%. The note is secured by a first mortgage and security interest in the real property and requires a monthly payment of principal and interest of approximately $33,000 with the remaining principal balance due at maturity on October 2, 1999.
The carrying amount of the mortgage notes payable is a reasonable estimate of fair value, as the pricing and terms of the notes are indicative of current rates and credit terms.
Senior notes payable. In January 1997, the Company completed a $220 million public debt offering of unsecured senior notes payable, issuing $100 million of notes with a coupon rate of 7.05% due January 15, 2002 (2002 Notes) and $120 million of notes with a coupon rate of 7.50% due January 15, 2007 (2007 Notes). The 2002 Notes and 2007 Notes have effective interest rates of approximately 7.34% and 7.74%, respectively. Interest is payable at the coupon rates semi-annually on January 15th and July 15th.
The fair value of the Company's 2002 Notes and 2007 Notes is based on the quoted market price of the notes as traded over-the-counter. As of December 31, 1998 and 1997, the estimated fair value of the 2002 Notes and 2007 Notes was $208 million and $225 million, respectively.
In February 1997, the Company prepaid its two issues of private placement debt, which included $72 million of 11.45% unsecured senior notes payable and $80 million of 10.41% unsecured senior notes payable. The weighted average amount of borrowings under these senior note issues during 1997 and 1996 was $22,800,000 and $178,250,000 at weighted average effective interest rates of 11.06% and 11.03%, respectively. The prepayment resulted in an extraordinary charge in the first quarter of 1997 of $11,427,000 consisting of a make-whole premium and other costs related to the prepayment.
Subordinated Convertible Bonds Payable. The Company's Convertible Dual Currency Subordinated Bonds (the Swiss Bonds) were sold in Switzerland pursuant to public subscription in 1990. The Swiss Bonds had a coupon rate of 8.5% and were convertible at the option of the holder at any time until July 9, 2000 into shares of the Company's common stock at a conversion price of $23.45 per share and a fixed exchange rate of Sfr. 1.41 per U.S. $1.00. In 1998, $10,000 of the 1990 Swiss Bonds, with accrued interest, were converted into 302 shares of common stock resulting in additional equity of $10,000, net of conversion and unamortized issuance costs. There were no conversions of Swiss Bonds in 1997 or 1996. Pursuant to the Company's call for early redemption, the remaining 1,489 outstanding Swiss Bonds were redeemed on December 30, 1998 for approximately $7,058,000. As of December 31, 1997, the estimated fair value of the Company's subordinated convertible bonds payable was $7,259,000 based on the quoted market price of bonds as traded in Switzerland.
Debt Covenants. Covenants and restrictions in the Company's various debt agreements include limitations on secured borrowings, restrictions covering the use of proceeds from asset sales and payments of dividends and requirements relating to the maintenance of specified financial covenants, including those
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
relating to minimum tangible net worth, fixed charge coverage and ratios of liabilities to minimum tangible net worth and asset values.
Annual Maturities. The aggregate amount of annual maturities of the Company's outstanding debt at December 31, 1998, for calendar years 1999 through 2003 and thereafter is $3,741,000, $504,000, $547,000, $100,594,000, $646,000 and $134,740,000, respectively. In addition, the outstanding balance of $69,000,000 at December 31, 1998 under the Company's unsecured revolving credit agreement matures on December 31, 2000, although certain events could require the earlier paydown of the outstanding balance.
Interest. Interest capitalized on construction in progress was $819,000, $517,000 and $895,000 in 1998, 1997 and 1996, respectively. Interest paid, net of interest capitalized, in 1998, 1997 and 1996 was $20,599,000, $14,374,000 and $21,547,000, respectively.
Inter-Group Loans. Revolving inter-Group loans owed by the Core Group to the Psychiatric Group are unsecured, bear interest at a floating rate equal to the weighted average interest rate on outstanding borrowings under the Company's revolving credit agreement (or, for periods in which there is no such revolving debt outstanding, the interest rate at which the Company could borrow on a revolving basis), and are prepayable without premium at any time, at the option of the Board. The weighted average outstanding amount of revolving inter-Group loans owed by the Core Group to the Psychiatric Group during 1998 was $1,870,000 at a weighted average interest rate of 6.28%.
Revolving and fixed rate inter-Group loans owed to the Core Group by the Psychiatric Group are unsecured and are prepayable without premium at any time, at the option of the Board. Revolving inter-Group loans owed to the Core Group bear interest at a floating rate equal to the prevailing prime rate plus 2% and fixed rate inter-Group loans owed to the Core Group bear interest at a fixed rate of 13%. The weighted average outstanding amount of revolving inter-Group loans owed to the Core Group by the Psychiatric Group during 1998, 1997 and 1996 was $1,106,000, $3,415,000, and $4,666,000 at weighted average interest rates of 10.50%, 10.44% and 10.27%, respectively. The weighted average outstanding amount of fixed rate inter-Group loans owed to the Core Group by the Psychiatric Group during 1998, 1997 and 1996 was $4,588,000, $9,175,000 and $9,175,000 at a weighted average interest rate of 13% for all three years. There were no new fixed rate loans made to the Psychiatric Group during these three years.
In July 1998, the Core Group received $11.2 million from the Psychiatric Group for the payoff of the entire outstanding balance of fixed and revolving inter-Group loans owed to the Core Group by the Psychiatric Group. The Company's Board has established certain management policies relating to the Core Group's commitment to provide inter-Group loans to the Psychiatric Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the Company's Board, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,865,000 at any one time outstanding, which limit is to be reduced dollar-for-dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no other inter-Group loans will be advanced by the Core Group to the Psychiatric Group.
The carrying amounts of the inter-Group loans are a reasonable estimate of fair value, as the pricing and terms of the loans are indicative of current rates and credit risk.
Nothing in the foregoing policies obligates the Board to cause the Core Group to provide funds to the Psychiatric Group or to cause the Psychiatric Group to provide funds to the Core Group if the Board determines it is in the best interests of the Company not to do so.
Equity Transactions. The proceeds of Core Group Common Stock issuances and the issuance of Series B Depositary Shares, as well as cash required to fund Core Group Common Stock dividends or repurchases and Series B Depositary Share dividends or redemptions are attributed solely to the Core Group
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
and the proceeds of Psychiatric Group Depositary Share issuances as well as cash required to fund Psychiatric Group Depositary Share dividends or repurchases are attributed solely to the Psychiatric Group.
General and Administrative Expenses. General and administrative expenses of the Company that cannot be directly attributed to either Group are allocated to the Core Group and the Psychiatric Group on the basis of their respective contributions to revenues (excluding inter-Group revenues and revenues from investment dispositions), provided that at no time will such expenses allocated to either Group be less than $62,500 per quarter.
REAL ESTATE PROPERTIES
The following table summarizes the Core Group's investment in health care real estate properties as of December 31, 1998:
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
- - ---------------
(1) Casa Blanca Clinic represents four separate facilities leased together under a single master lease. Fannin Medical Buildings represent two separate facilities master-leased to affiliated tenants under separate leases, with one such facility encumbered by a $17,495 mortgage note payable. Emerson Medical Office Building/Surgery Center represents two separate facilities, one of which is master-leased and the other leased to multiple tenants.
(2) Murfreesboro Medical Clinic is encumbered by a $3,277 mortgage note payable.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
A substantial portion of the Core Group's properties are leased to single-tenant operators under "net" leases pursuant to which the lessees are responsible for all maintenance, repairs, taxes and insurance of the leased properties. The leases provide for the payment of minimum base rent and additional rent during the fixed term and any renewal terms. Additional rent is generally based on the increase in annual gross revenues of the related facility or the consumer price index as specified in the lease agreements. The Core Group has the right to approve capital expenditures at such properties, the option to fund certain capital expenditures and, in certain situations, is obligated to fund approved capital expenditures on terms comparable to the original investment. The base and additional rent provisions of the leases are amended when such capital expenditures are funded to reflect the Core Group's increased investment. At December 31, 1998, the Core Group had no commitments to fund capital expenditures pursuant to these rights and obligations.
Many of the Core Group's medical office/clinic facilities are leased to multiple tenants on a gross or modified net basis pursuant to which the Core Group, as lessor, is responsible for a portion of the operating costs of the building, including but not limited to the cost of maintenance, repairs, insurance and taxes on the leased properties. In general, the Core Group is also initially responsible for capital expenditures, leasing commissions and tenant improvements at these buildings, subject to reimbursement from tenants in some instances.
At December 31, 1998, the Core Group had construction in progress of $14,247,000. As of December 31, 1998, the Core Group had funded $5,230,000 of a $9.5 million commitment to develop a skilled nursing facility in Las Vegas, Nevada to be operated by an experienced operator of skilled nursing facilities. As of December 31, 1998, the Core Group had funded $8,329,000 of an $18.6 million commitment to develop three assisted living facilities to be managed by an experienced operator of assisted living facilities. The Core Group has a $22.5 million forward funding commitment to develop up to nine Alzheimer's care facilities to be managed by the same operator that currently manages two existing Alzheimer's care facilities owned by the Core Group. As of December 31, 1998, $688,000 was funded under this commitment for the development of one facility having a total development cost of approximately $2.8 million. The Core Group has identified a second facility site under this commitment having a total development cost of approximately $2.8 million. The Core Group also has a $5.7 million commitment to develop a medical office/clinic facility in Roseburg, Oregon to be master-leased to the operator of the adjacent hospital.
Six of the Core Group's acute care properties are leased to subsidiaries of American Medical International, Inc. (AMI), a subsidiary of Tenet Healthcare Corporation. The six leases are covered by cross-default provisions and the lease obligations are unconditionally guaranteed by AMI. In 1998, revenues from these leases accounted for 42% of the Core Group's total revenues.
Kendall Regional Medical Center (Kendall) is leased to a subsidiary of Columbia/HCA Healthcare Corporation (Columbia). Aggregate revenues from the lease, which was originally scheduled to mature in February 1999, were approximately $10.3 million in 1998, or 10% of the Core Group's total revenues. Pursuant to the terms of the lease, Columbia has exercised its option to purchase Kendall at fair market value. The purchase price of $105 million will be paid in cash, or at the option of the Company, a combination of cash and debt relief. The Company currently intends to effect the transaction as a "deferred like-kind" 1031 exchange for tax purposes. The first part of the exchange, the transfer of Kendall to Columbia, is currently scheduled to occur on April 15, 1999. The Company would complete the exchange by acquiring new investment properties within the time limits imposed by federal tax law, if possible. If the Company is successful in identifying and closing on a sufficient amount of new investments within the required time limits, the Company should not recognize current taxable gain as a result of the transaction. In that event, there should be no impact on the Company's REIT distribution requirements. Even though the Company may not recognize gain on the transaction for tax purposes, the Core Group expects to be able to recognize a gain of over $50 million for book purposes. The Company cannot be assured that total revenues generated by new investments acquired to effect the exchange will equal the annual revenues currently generated by the Kendall investment, nor is it certain that the Company will complete the transaction as an exchange. If the Company
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
does not complete the transaction as an exchange, the amount of the Company's tax liability, the impact on its REIT distribution requirements and the amount of gain, net of taxes if any, recognized for book purposes would depend on the amount of gain recognized for tax purposes, any losses recognized by the Company on sales of other assets and various tax elections available to the Company.
Future minimum annual rentals, assuming the sale of Kendall on April 15, 1999, under the Core Group's noncancellable operating leases for calendar years 1999 through 2003 are approximately $88,640,000, $84,950,000, $79,920,000, $74,770,000, and $73,150,000, respectively.
MORTGAGE NOTE RECEIVABLE
SCCI Hospital -- Houston Central $4,400,000. The Core Group has a mortgage note receivable secured by a first mortgage and security interest in the real property of a long-term acute care facility in Houston, Texas. The note has an initial term of ten years with two optional ten-year extension terms. The initial term maturity date is June 30, 2007. The interest rate on the note is 10.50% with interest only payable monthly through June 30, 1999 and monthly principal and interest payments of $40,000 payable thereafter. Pursuant to the terms of the mortgage note receivable, the Core Group may receive additional interest each year based on the increase in annual operating revenues of the facility.
The carrying amount of the mortgage note receivable is a reasonable estimate of fair value, as the pricing and terms of the note are indicative of current rates and credit risk.
OTHER NOTE RECEIVABLE
In 1998, the Core Group committed to advance funds on a senior subordinated note due from the operator of an Alzheimer's care facility for a total maximum principal amount of $1,902,000. The note is secured by a pledge of stock in the operator and is personally guaranteed by one of its principals. Advances under the note are conditioned upon borrower's compliance with various covenants. The Core Group has no obligation to make principal advances after February 27, 2003. As of December 31, 1998, $1,468,000 was outstanding under the note, which included principal advanced of $1,283,000 and accrued interest of $185,000. Prior to December 31, 2002, interest accrues on the principal balance of the note at a rate of 18% per annum and will be added to the outstanding principal balance on a quarterly basis. Accrued interest is payable quarterly as it accrues commencing January 1, 2003 until March 31, 2006, subject to an intercreditor agreement and certain earnings requirements of the operator. Commencing April 1, 2006, quarterly principal and interest payments sufficient to amortize the principal amount of the loan as of March 31, 2006 together with unpaid interest are due in equal quarterly installments until April 1, 2012 at which time all unpaid principal and interest amounts are due and payable.
The pricing and terms of the other note receivable is indicative of current rates and credit risk, and therefore, the current carrying amount of this financial instrument is a reasonable estimate of fair value.
DIRECT FINANCING LEASES
In connection with its investments in certain acute and long-term care properties, the Core Group has provided equipment leasing for terms of five to seven years which are classified as direct financing leases. As of December 31, 1998, the Core Group's aggregate net investment in these direct financing leases was $1,975,000, represented by total minimum lease payments receivable of $2,163,000 less unearned income of $188,000. Future minimum annual lease payments under these leases for calendar years 1999 through 2002 are approximately $1,342,000, $704,000, $94,000 and $23,000, respectively.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
PENSION PLANS
The Company has a defined contribution pension plan covering all of its employees. Pension expense allocated to the Core Group in 1998, 1997 and 1996 was $272,000, $188,000 and $222,000, respectively.
The Company has an unfunded defined benefit pension plan covering non-employee members of its Board of Directors elected prior to 1997 upon completion of sixty months of membership on the Board. The benefits, limited to ten years, are based on years of service and the annual base director fee in effect as of the date a director ceases to be a member of the Board. Net periodic pension cost allocated to the Core Group in 1998, 1997 and 1996 was $74,000, $88,000 and $177,000, respectively. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding this plan.
STOCK INCENTIVE PLANS
The Company's stock incentive plans provide for the issuance of shares of the Company's stock to directors and key employees as stock incentives. As allowed by SFAS 123, "Accounting for Stock-Based Compensation", the Company measures employee stock-based compensation expense using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees". Total stock-based compensation expense recognized under APB 25 and allocated to the Core Group in 1998, 1997 and 1996 was $1,243,000, $1,319,000 and $1,139,000, respectively. If the fair value based method of accounting defined by SFAS 123 had been used to measure and recognize stock-based compensation expense, the pro forma effect on the reported amounts of earnings per share of the Core Group for 1998, 1997 and 1996 would not have been material. The pro forma effect for 1998, 1997 and 1996 may not be representative of the pro forma effect in future years because it does not take into consideration stock-based incentives granted prior to 1995. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding the Company's stock incentive plans.
ATTRIBUTED EQUITY
Sale of Stock to Psychiatric Group. On July 24, 1998, the Core Group sold 833,067 new shares of Core Group Common Stock to the Company's Psychiatric Group at a price of $25.9407 per share, which the Psychiatric Group concurrently distributed to holders of Psychiatric Group Depositary Shares as a special stock dividend.
8.6% Cumulative Redeemable Preferred Stock, Series B. The Company has 4,000,000 Series B Depositary Shares outstanding which represent 40,000 shares of Series B Preferred Stock. Each Series B Depositary Share represents 1/100 of a share of Series B Preferred Stock, and entitles the holder to such proportion of all the rights, preferences and privileges of the Series B Preferred Stock represented thereby. The Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock, its Series A Preferred Stock (when and if issued) and its Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights. The annual dividend rate and liquidation preference with respect to each Series B Depositary Share are $2.15 and $25, respectively (equivalent to $215 and $2,500 per share of Series B Preferred Stock, respectively). Dividends on the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are cumulative and, if and when declared, are payable quarterly in arrears on the last day of February, May, August and November of each year. On or after October 27, 2002, the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, may be redeemed, in whole or in part, at the option of the Company at a redemption price of $25 per Series B Depositary Share (equivalent to $2,500 per share of Series B Preferred Stock), plus accrued and unpaid dividends thereon. The redemption price, other than the portion representing accrued and unpaid dividends, is payable solely out of proceeds from the sale of other capital stock of the Company. The proceeds from the sale of the Series B
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Depositary Shares, and the Series B Preferred Stock represented thereby, as well as the dividends payable thereon, have been attributed to the Company's Core Group for financial accounting and reporting purposes.
Preferred Stock Purchase Rights Plan. The Company has a preferred stock purchase rights plan which provides for the distribution of one preferred stock purchase right (each a Right) to shareholders for each outstanding share of common stock. Under certain conditions, each Right may be exercised to purchase 1/100 of a share of preferred stock, Series A, par value $.01 per share (the Series A Preferred Shares), of the Company at a price of $45. The Company's Psychiatric Group Depositary Shares do not include the Rights or entitle holders thereof to receive the Rights, which are applicable only to the Company's Core Group Common Stock. The Series A Preferred Stock (when and if issued) rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights, but rank junior to the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding the Company's preferred stock purchase rights plan.
EARNINGS PER SHARE
The following is a reconciliation of the income and share amounts used in the basic and diluted per share computations of income before extraordinary item attributable to Core Group Common Stock:
DIVIDENDS
A quarterly dividend of $.565 per share for Core Group Common Stock, or approximately $14,116,000, was declared by the Board of Directors on January 22, 1999, payable on February 24, 1999 to shareholders of record on February 10, 1999. A dividend of $.5375 per share for Series B Depositary Shares was declared by the Board of Directors on January 22, 1999, payable March 1, 1999 to shareholders of record February 15, 1999. This dividend was for the regular quarterly period ended February 28, 1999 and approximately $717,000 was accrued at December 31, 1998. The aggregate dividends of $14,833,000 have been reflected as dividends payable in the accompanying financial statements as of December 31, 1998.
Cash dividends of $2.18 per share paid on Core Group Common during 1998 are characterized as $1.076 of ordinary income and $1.104 of return of capital for tax purposes. Cash dividends of $2.15 per share paid on Series B Depositary Shares during 1998 are characterized entirely as ordinary income for income tax purposes.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO CORE GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
In general, cash dividends on the Company's Core Group Common Stock and Psychiatric Group Depositary Shares are limited by the Company's unsecured revolving credit agreement to 95% of cash flow available for debt service, less interest expense, plus gains on asset dispositions and certain proceeds from the disposition of Psychiatric Group assets.
QUARTERLY FINANCIAL DATA (UNAUDITED)
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To American Health Properties, Inc.:
We have audited the accompanying combined balance sheets of the Psychiatric Group (a business unit of American Health Properties, Inc.) as of December 31, 1998 and 1997, and the related combined statements of operations, total attributed equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the management of American Health Properties, Inc. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Psychiatric Group as of December 31, 1998 and 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Denver, Colorado January 22, 1999 (except with respect to the matter discussed on page related to the sale of Rock Creek Center, as to which the date is February 24, 1999).
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
PSYCHIATRIC GROUP COMBINED BALANCE SHEETS
ASSETS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
PSYCHIATRIC GROUP COMBINED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
PSYCHIATRIC GROUP COMBINED STATEMENTS OF TOTAL ATTRIBUTED EQUITY
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
PSYCHIATRIC GROUP COMBINED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS
THE COMPANY
American Health Properties, Inc., a Delaware corporation (the Company, which term refers to the Company and its subsidiaries unless the context otherwise requires), is a self-administered real estate investment trust (REIT) that commenced operations in 1987. The Company has investments in health care properties, including acute care, rehabilitation, long-term acute care and psychiatric hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities.
The Psychiatric Group Depositary Shares are intended to reflect the separate financial performance of the Company's investments in psychiatric hospitals (the Psychiatric Group). The Company's common stock (the Core Group Common Stock) is intended to reflect the separate financial performance of the Company's investments in acute care, rehabilitation and long-term acute care hospitals, skilled nursing, assisted living, Alzheimer's care and medical office/clinic facilities (the Core Group). The Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are attributed to the Company's Core Group for financial accounting and reporting purposes.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation. The financial statements of the Psychiatric Group include the financial position, results of operations and cash flows of the Company's psychiatric hospital investments, an allocated portion of the Company's general and administrative expense, an attributed amount of inter-Group loans and an attributed amount of the Company's stockholders' equity. The Psychiatric Group financial statements are prepared using the amounts included in the Company's consolidated financial statements.
Although the financial statements of the Psychiatric Group and the Core Group separately report the assets, liabilities (including contingent liabilities), stockholders' equity and items of income, expense and cash flow of the Company attributed to each such Group, such attribution does not affect the legal title to assets or responsibility for liabilities of the Company or any of its subsidiaries. Furthermore, such attribution does not affect the rights of creditors of the Company or any subsidiary, including rights under financing covenants.
Each holder of Psychiatric Group Depositary Shares, Core Group Common Stock or Series B Depositary Shares is a holder of an issue of capital stock of the entire Company and is subject to risks associated with an investment in the Company and all of its businesses, assets and liabilities. Financial effects arising from one Group that affect the Company's consolidated results of operations, financial condition, cash flows or borrowing costs may also affect the results of operations, financial condition, cash flows or borrowing costs of the other Group. In addition, net losses of either Group, as well as dividends and distributions on, and repurchases or redemptions of, Psychiatric Group Depositary Shares, Core Group Common Stock or Series B Depositary Shares will reduce the funds of the Company legally available for dividends on Psychiatric Group Depositary Shares, Core Group Common Stock and Series B Depositary Shares. Accordingly, the Psychiatric Group's financial statements should be read in conjunction with the Company's consolidated financial statements and the financial statements of the Core Group.
These financial statements include the accounts of the Psychiatric Group business. The Psychiatric Group and the Core Group financial statements, taken together, comprise all of the accounts included in the Company's consolidated financial statements.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Cash and Short-Term Investments. Cash and short-term investments consist of cash and all highly liquid investments with an original maturity date of less than three months and are stated at cost which approximates fair value.
Real Estate Properties. The Psychiatric Group records properties at cost and recognizes depreciation on a straight-line basis over 21 years, the estimated useful lives of the buildings and improvements.
Impairment of Real Estate Properties and Notes Receivable. The Psychiatric Group reviews the carrying value of its real estate properties and notes receivable for the possible impairment of value whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. In general, an impairment of such assets would be indicated if the estimated future cash flows expected to result from the use of such assets and their eventual disposition is less than their carrying amounts.
Deferred Income. Fees received, net of related direct costs, associated with the origination or amendment of leases and mortgage notes receivable are deferred and amortized at a constant effective rate over the remaining term of the related leases and mortgage notes receivable.
Federal Income Taxes. The Company intends at all times to operate so as to qualify as a REIT under Sections 856 to 860 of the Internal Revenue Code. As such, the Company generally will not be subject to federal income tax to the extent it distributes to shareholders at least 100% of its taxable income.
Qualification as a REIT under Sections 856 to 860 of the Internal Revenue Code applies to the Company as a whole, rather than the Core Group or Psychiatric Group individually. Dividends paid by the Company on its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares must be sufficient in the aggregate for the Company to meet the minimum distribution requirements of the Internal Revenue Code. The Company's earnings and profits as a whole, without reference to the Core Group or Psychiatric Group individually, is used to determine the taxable character of dividends paid to holders of its Core Group Common Stock, Series B Depositary Shares and Psychiatric Group Depositary Shares, with earnings and profits allocated first to Series B Depositary Shares.
Earnings and profits, which determine the taxable character of dividends paid to stockholders, differ from net income for financial reporting purposes due primarily to timing differences in the recognition of deferred income, impairment losses and various accruals and differences between the estimated useful lives used to compute depreciation for financial statement purposes and a 40-year life generally used in determining earnings and profits. The cost basis of the Company's real estate properties is generally the same for financial reporting and earnings and profits purposes, except for properties written down for financial reporting purposes and properties for which the previous owner's basis is required to be carried forward for tax purposes.
New Accounting Standards. In the first quarter of 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. The adoption of this statement had no impact on the Psychiatric Group's financial statements.
In 1998, the Company adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", which establishes standards for reporting financial and descriptive information about reportable operating segments. In general, reportable operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Psychiatric Group is a separate operating segment of the Company and does not have separate reportable operating segments.
In February 1998, the Financial Accounting Standards Board issued SFAS No. 132, "Employer's Disclosures about Pensions and Other Post Retirement Benefits". SFAS No. 132 revises employer's disclosures about pension and other post retirement benefits, requires additional information on changes in the
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
benefit obligations and fair values of plan assets and eliminates certain previous disclosures. The adoption of this statement in 1998 had no impact on the Psychiatric Group's financial statements.
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", which establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. It also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. The required adoption of this statement in 2000 is not expected to have a material impact on the Psychiatric Group's financial statements.
In April 1998, the AICPA issued Statement of Position ("SOP") 98-5, "Reporting on the Costs of Start-Up Activities". In general, SOP 98-5 requires costs of start-up activities and organization costs to be expensed as incurred. The adoption of SOP 98-5 in 1998 had no impact on the Psychiatric Group's financial statements.
CORPORATE ACTIVITIES, INTER-GROUP LOANS, THIRD-PARTY DEBT AND EQUITY
Financial Activities. As a matter of policy, the Company manages all financial activities on a centralized, consolidated basis. Such financial activities include the investment of surplus cash; the issuance and repayment of all short-term and long-term debt; and the issuance of common and preferred stock. These activities are then attributed to the Core Group and the Psychiatric Group in the manner described herein.
Third-Party Debt. All of the Company's third-party debt ($308,936,000 and $243,813,000 at December 31, 1998 and 1997, respectively) has been attributed to the Core Group; however, the Psychiatric Group, together with the Core Group, is subject to all of the terms, restrictions and covenants relating to such third- party debt. These include limitations on secured borrowings, restrictions covering the use of proceeds from asset sales and payments of dividends and requirements relating to the maintenance of specified financial covenants, including those relating to minimum tangible net worth, fixed charge coverage and ratios of liabilities to minimum tangible net worth and asset values. The third-party debt attributed to the Core Group at December 31, 1998 includes $69,000,000 of unsecured bank loans payable, $219,164,000 of unsecured senior notes payable and $20,772,000 of mortgage indebtedness. The aggregate amount of annual maturities of the Company's outstanding debt at December 31, 1998, for calendar years 1999 through 2003 and thereafter is $3,741,000, $504,000, $547,000, $100,594,000, $646,000, and $134,740,000, respectively. In addition, the outstanding balance of $69,000,000 at December 31, 1998 under the Company's unsecured revolving credit agreement matures on December 31, 2000, although certain events could require the earlier paydown of the outstanding balance. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding the Company's third-party debt.
Inter-Group Loans. Revolving inter-Group loans owed to the Psychiatric Group by the Core Group are unsecured, bear interest at a floating rate equal to the weighted average interest rate on outstanding borrowings under the Company's revolving credit agreement (or, for periods in which there is no such revolving debt outstanding, the interest rate at which the Company could borrow on a revolving basis), and are prepayable without premium at any time, at the option of the Board. The weighted average outstanding amount of revolving inter-Group loans owed to the Psychiatric Group by the Core Group during 1998 was $1,870,000 at a weighted average interest rate of 6.28%.
Revolving and fixed rate inter-Group loans owed by the Psychiatric Group to the Core Group are unsecured and are prepayable without premium at any time, at the option of the Board. Revolving inter-Group loans owed by the Psychiatric Group bear interest at a floating rate equal to the prevailing prime rate plus 2% and fixed rate inter-Group loans owed by the Psychiatric Group bear interest at a fixed rate of 13%. The weighted average outstanding amount of revolving inter-Group loans owed by the Psychiatric Group to the Core Group during 1998, 1997 and 1996 was $1,106,000, $3,415,000, and $4,666,000 at weighted average
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
interest rates of 10.50%, 10.44% and 10.27%, respectively. The weighted average outstanding amount of fixed rate inter-Group loans owed by the Psychiatric Group to the Core Group during 1998, 1997 and 1996 was $4,588,000, $9,175,000 and $9,175,000 at a weighted average interest rate of 13% for all three years. There were no new fixed rate loans made to the Psychiatric Group during these three years.
In July 1998, the Psychiatric Group paid off the entire $11.2 million outstanding balance of fixed and revolving inter-Group loans owed to the Core Group with a portion of the proceeds the Psychiatric Group received from the payoff of the Four Winds mortgage notes receivable. The Company's Board has established certain management policies relating to the Core Group's commitment to provide inter-Group loans to the Psychiatric Group. Under the policies currently in effect, which may be modified or rescinded at any time in the sole discretion of the Company's Board, the aggregate revolving inter-Group loans owed by the Psychiatric Group to the Core Group are limited to a maximum of $7,865,000 at any one time outstanding, which limit is to be reduced dollar-for-dollar by any permanent repayment in the future of borrowings under a revolving credit agreement provided to a Psychiatric Group hospital operator; provided that the limit on the aggregate revolving inter-Group loans will not be reduced below $5,000,000. Except for such revolving inter-Group loans, no other inter-Group loans will be advanced by the Core Group to the Psychiatric Group.
The carrying amounts of the inter-Group loans are a reasonable estimate of fair value, as the pricing and terms of the loans are indicative of current rates and credit risk.
Nothing in the foregoing policies obligates the Board to cause the Core Group to provide funds to the Psychiatric Group or to cause the Psychiatric Group to provide funds to the Core Group if the Board determines it is in the best interests of the Company not to do so.
Equity Transactions. The proceeds of Core Group Common Stock issuances and the issuance of Series B Depositary Shares, as well as cash required to fund Core Group Common Stock dividends or repurchases and Series B Depositary Share dividends or redemptions are attributed solely to the Core Group and the proceeds of Psychiatric Group Depositary Share issuances as well as cash required to fund Psychiatric Group Depositary Share dividends or repurchases are attributed solely to the Psychiatric Group.
General and Administrative Expenses. General and administrative expenses of the Company that cannot be directly attributed to either Group are allocated to the Psychiatric Group and the Core Group on the basis of their respective contributions to revenues (excluding inter-Group revenues and revenues from investment dispositions), provided that at no time will such expenses allocated to either Group be less than $62,500 per quarter. All general and administrative expenses directly attributed or allocated to the Psychiatric Group are generally paid currently, regardless of when such expenses are paid to third parties by the Company.
REAL ESTATE PROPERTIES
The following table summarizes the Psychiatric Group's investment in health care real estate properties as of December 31, 1998:
The fundamental ongoing changes in the psychiatric industry and the resulting negative impact on operator financial performance have resulted in the periodic restructuring of psychiatric operator payment
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
obligations, the closing of one psychiatric hospital and significant impairment losses on psychiatric investments, including an $11 million charge in 1997 and a $8.3 million charge in 1998.
In late 1995, the operator of the Northpointe and Sunrise Regional Medical Center (Sunrise) facilities was experiencing operational and cash flow difficulties which negatively impacted the operator's ability to pay rental and interest obligations to the Psychiatric Group. During 1996, the Psychiatric Group modified the Northpointe agreements to allow for the deferral of rent and interest payments while certain restructuring and restaffing of the facility occurred. In late 1996, adverse publicity from a lawsuit filed against the operator alleging widespread irregularities materially exacerbated the operational and financial difficulties of Northpointe and Sunrise. Subsequently, the census at Northpointe fell significantly to a level that made it appear unlikely that the operator could continue operations at the facility and the operator was unable to continue paying its obligations to the Psychiatric Group after January 1997. Sunrise suffered from declining census and significant deterioration of its cash flow, which made it difficult to continue paying its obligations to the Psychiatric Group. The volatile circumstances at Sunrise and the deterioration in its cash flows and census levels appeared likely to preclude the operator from continuing operations at the facility. A range of options for these two facilities was explored, including the transfer of the operations to new operators, closing the facilities, conversion of the facilities to an alternative use or sale of the properties. As a result of this review, the Psychiatric Group recorded an $11,000,000 charge in the first quarter of 1997 for impairment of the carrying value of these two investments. Of this amount, $5,100,000 related to the Psychiatric Group's investment in Northpointe, which included a $1,675,000 reserve against the entire unpaid balance under a revolving credit agreement and a $3,425,000 reduction in the carrying value of its net real estate investment. The remaining impairment charge of $5,900,000 related to the Psychiatric Group's investment in Sunrise, which included a $49,000 reserve against the entire unpaid balance under a revolving credit agreement and a $5,851,000 reduction in the carrying value of its net real estate investment. The financial and operational problems at the Northpointe and Sunrise facilities continued to worsen during 1997. The operator of Northpointe ceased hospital operations during the second quarter of 1997 and a restructuring of Sunrise's obligations to the Psychiatric Group was completed in the fourth quarter of 1997.
The Northpointe property remained vacant during 1998 and the Psychiatric Group incurred $450,000 ($.22 per depositary share on a diluted basis) of maintenance and security costs. Although the Psychiatric Group expects to incur approximately $75,000 per quarter for ongoing maintenance and security costs while it continues to seek alternate uses or a buyer for the property, the Psychiatric Group cannot be assured that other unexpected costs will not be incurred. Attempts to locate an alternate healthcare operator for the Northpointe property have proven largely unsuccessful. After assessing the various alternatives for the facility and reviewing the estimated net realizable value of the property under each potential alternative, the Psychiatric Group recorded an impairment charge at the end of 1998, which reduced the carrying value of the investment to $1,300,000. If an acceptable healthcare operator is not identified for the Northpointe facility in the near term, the property will likely be marketed for sale. However, the Psychiatric Group cannot be assured that any sale price would equal or exceed the current carrying value of the Northpointe property.
At December 31, 1998, the Sunrise property had a carrying value of $2,631,000. In September 1998, a new operator assumed all operational responsibility for the hospital and entered into a new five-year lease with effective monthly rent of $60,000 ($.029 per depositary share on a diluted basis). In connection with the change in operators, the Psychiatric Group received a one-time payment of $347,000 ($.17 per depositary share on a diluted basis) from the former operator to settle certain of the obligations owed to the Psychiatric Group. Although the new operator has fulfilled its obligations to the Psychiatric Group under the lease so far, the new operator has experienced cash flow difficulties primarily as a result of delays in obtaining Baker Act certification. As a result, the Psychiatric Group provided the operator with a $200,000 working capital loan at the end of 1998, and subsequent to year-end, the operator requested $700,000 of additional working capital loans. Although this request is still being evaluated, the Company likely will provide the additional loans. The Company cannot be assured that the operator will be successful and, if it were to cease operations, an
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
impairment charge to reduce the carrying value of the Sunrise property and any related outstanding working capital loans would be likely. The Company will continue to encourage the operator to pursue financing alternatives that might enable it to acquire the property and repay its borrowings from the Company.
The operator of Rock Creek Center (RCC) experienced continuing financial and operational difficulties over the past several years. In 1996, RCC experienced substantial payor reimbursement issues and lower than expected census that adversely impacted its cash flow and its ability to pay its rental and interest obligations to the Psychiatric Group. As a result, the Psychiatric Group modified the RCC agreements in 1996 to allow for the partial deferral of base rent payments while the operator took certain actions to stabilize operations and implemented its revised business plan. The maturity date of the $2.5 million balance outstanding under the RCC revolving credit agreement and the initial term of the RCC lease were extended on several occasions with the latest extension to March 31, 1999. In June 1998, the operator of the RCC facility informed the Psychiatric Group that it had incurred a material, unanticipated liability to Medicare, which imperiled the continuing operation of the facility. RCC met its rent and interest obligations to the Psychiatric Group through November 1998, however, RCC made its November payments late due to cash flow problems. In December 1998, cash flow problems at RCC became so severe that the operator of the RCC facility defaulted on all of its obligations to the Psychiatric Group and the Psychiatric Group delivered formal notice of default to RCC for failure to pay such obligations. Although RCC had been involved in negotiations to effect a transfer of its operations, those negotiations were discontinued. As a result, the carrying value of the RCC property was written down to $1,200,000 and the Company's net investment in related notes and various other obligations owed to it by the operator of RCC were totally written off. Subsequent to year-end on February 24, 1999, the Psychiatric Group sold its total RCC investment to the current operator for a cash price of $2.5 million. The Company considered other alternatives for the property and evaluated offers from other potential buyers before agreeing to sell to the current operator. The sale to the current operator represented the highest price and most certain transaction the Psychiatric Group was able to achieve from qualified potential purchasers of the property.
Future minimum annual rentals under the Psychiatric Group's noncancellable operating leases for calendar years 1999 through 2002 are approximately $720,000, and approximately $540,000 for calendar year 2003. These amounts do not reflect any adjustments for the nonpayment of rent or the deferral of rent which could occur in the future.
MORTGAGE NOTES RECEIVABLE
Four Winds. The Psychiatric Group had two mortgage notes receivable secured by first mortgages and security interests in the real property of Four Winds, two psychiatric facilities located in Saratoga Springs and Katonah, New York. The Saratoga Springs note had an initial term of ten years with a maturity date of June 30, 1999, bore interest at a rate of 12.42% and required monthly principal and interest payments of $194,000. The Katonah note had an initial term of ten years with a maturity date of November 30, 2002, bore interest at rates of 13.44%, 13.80% and 14.13%, in 1996, 1997 and 1998, respectively and required monthly payments of interest only. As of December 31, 1997, the carrying amount of the mortgage notes receivable was a reasonable estimate of fair value, as the pricing and terms of the notes were indicative of current rates and credit risk. On July 1, 1998, the Psychiatric Group received $35 million as prepayment in full of the two Four Winds mortgage notes receivable resulting in an impairment loss of $2.73 million.
OTHER NOTES RECEIVABLE
The Psychiatric Group has provided financing at variable rates to certain hospital operators under revolving credit agreements and working capital loans. Borrowings under these agreements are conditioned upon the borrower's compliance with various covenants and are partially secured by accounts receivable, other personal property and/or issued and outstanding shares of capital stock of the operators. As of December 31,
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
1998, $195,000 was outstanding under a $200,000 working capital loan provided to one psychiatric hospital operator at an annual interest rate of 12%. Interest only on the note is payable monthly through August 1, 1999. Commencing September 1, 1999, principal and interest payments of $35,000 are payable monthly until maturity on February 1, 2000. The pricing and terms of other notes receivable is indicative of current rates and credit risk, and therefore, the current carrying amount of these financial instruments is a reasonable estimate of fair value. During 1998, $2,485,000 of outstanding borrowings were written off as part of a $5.6 million impairment loss recorded on psychiatric investments, and during 1997, $1,724,000 of outstanding borrowings were written off as part of an $11.0 million impairment loss recorded on psychiatric investments.
PENSION PLANS
The Company has a defined contribution pension plan covering all of its employees. Pension expense allocated to the Psychiatric Group in 1998, 1997 and 1996 was $15,000, $19,000, and $25,000, respectively.
The Company has an unfunded defined benefit pension plan covering non-employee members of its Board of Directors elected prior to 1997 upon completion of sixty months of membership on the Board. The benefits, limited to ten years, are based on years of service and the annual base director fee in effect as of the date a director ceases to be a member of the Board. Net periodic pension cost allocated to the Psychiatric Group in 1998, 1997 and 1996 was $4,000, $9,000 and $20,000, respectively. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding this plan.
STOCK INCENTIVE PLANS
The Company's stock incentive plans provide for the issuance of shares of the Company's stock to directors and key employees as stock incentives. As allowed by SFAS 123, "Accounting for Stock-Based Compensation", the Company measures employee stock-based compensation expense using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees". Total stock-based compensation expense recognized under APB 25 and allocated to the Psychiatric Group in 1998, 1997 and 1996 was $91,000, $108,000 and $112,000, respectively. If the fair value based method of accounting defined by SFAS 123 had been used to measure and recognize stock-based compensation expense, the pro forma effect on the reported amounts of earnings per share of the Psychiatric Group for 1998, 1997 and 1996 would not have been material. The pro forma effect for 1998, 1997 and 1996 may not be representative of the pro forma effect in future years because it does not take into consideration stock-based incentives granted prior to 1995. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding the Company's stock incentive plans.
COMPANY PREFERRED EQUITY
8.6% Cumulative Redeemable Preferred Stock, Series B. The Company has 4,000,000 Series B Depositary Shares outstanding which represent 40,000 shares of Series B Preferred Stock. Each Series B Depositary Share represents 1/100 of a share of Series B Preferred Stock, and entitles the holder to such proportion of all the rights, preferences and privileges of the Series B Preferred Stock represented thereby. The annual dividend rate and liquidation preference with respect to each Series B Depositary Share are $2.15 and $25, respectively (equivalent to $215 and $2,500 per share of Series B Preferred Stock, respectively). Dividends on the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, are cumulative. Although the proceeds from the sale of the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, as well as the dividends payable thereon, have been attributed to the Company's Core Group for financial accounting and reporting purposes, the Series B Depositary Shares, and the Series B Preferred Stock represented thereby, rank senior to the Company's Core Group Common Stock, its Series A Preferred Stock (when and if issued) and its Psychiatric Group Depositary Shares, and the
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights.
Preferred Stock Purchase Rights Plan. The Company has a preferred stock purchase rights plan which provides for the distribution of one preferred stock purchase right (each a Right) to shareholders for each outstanding share of common stock. Under certain conditions, each Right may be exercised to purchase 1/100 of a share of preferred stock, Series A, par value $.01 per share (the Series A Preferred Shares), of the Company at a price of $45. The Company's Psychiatric Group Depositary Shares do not include the Rights or entitle holders thereof to receive the Rights, which are applicable only to the Company's Core Group Common Stock. The Series A Preferred Stock (when and if issued) rank senior to the Company's Core Group Common Stock and its Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, with respect to dividend payments and liquidation rights, but rank junior to the Company's Series B Depositary Shares, and the Series B Preferred Stock represented thereby. The Notes to the Consolidated Financial Statements of the Company should be read for further details regarding the Company's preferred stock purchase rights plan.
EARNINGS PER SHARE
The following is a reconciliation of the income and share amounts used in the basic and diluted per share computations of net income or loss attributable to Psychiatric Group Depositary Shares:
DIVIDENDS AND REDEMPTION PROVISIONS
A quarterly dividend of $.095 per share for Psychiatric Group Depositary Shares, or approximately $198,000, was declared by the Board of Directors on January 22, 1999, payable on February 24, 1999 to shareholders of record on February 10, 1999. The dividend has been reflected as dividends payable in the accompanying financial statements as of December 31, 1998.
On July 24, 1998, the Psychiatric Group used proceeds from the payoff of the Four Winds mortgage notes receivable to purchase 833,067 new shares of Core Group Common Stock from the Company's Core Group at a price of $25.9407 per share and concurrently distributed the shares to holders of Psychiatric Group Depositary Shares as a special stock dividend. Holders of Psychiatric Group Depositary Shares received 0.4 shares of Core Group Common Stock for each Psychiatric Group Depositary Share held and were paid cash-in-lieu of fractional shares of Core Group Common Stock based on the price of $25.9407.
Dividends of $12.62628 per share, including $2.25 of cash dividends and a special stock dividend valued at $10.37628, paid on Psychiatric Group Depositary Shares during 1998 are characterized as $6.2325 of ordinary income and $6.39378 of return of capital for tax purposes. For Psychiatric Group Depositary Share holders of record on July 17, 1998, the initial tax basis in the Core Group Common Stock distributed as a special stock dividend is $25.9407 per share of Core Group Common Stock.
In general, cash dividends on the Company's Core Group Common Stock and Psychiatric Group Depositary Shares are limited by the Company's unsecured revolving credit agreement to 95% of cash flow
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
available for debt service, less interest expense, plus gains on asset dispositions and certain proceeds from the disposition of Psychiatric Group assets.
Dividends on the Company's Psychiatric Group Depositary Shares are determined each quarter based upon the operating results of the Company's Psychiatric Group. It continues to be the policy of the Board to maintain a dividend payout ratio for each quarter in excess of 90 percent of the Psychiatric Group's funds from operations for the related quarter, when possible. With the disposition of the RCC investment, on February 24, 1999, the Sunrise investment is currently the sole income-producing property of the Company's Psychiatric Group and the operator of Sunrise is experiencing cash flow difficulties. Therefore, commencing in the second quarter of 1999, the Psychiatric Group's funds from operations may not be sufficient to permit the payment of a dividend on the Psychiatric Group Depositary Shares.
The Company intends to periodically evaluate the financial position of the Psychiatric Group, including an assessment of the potential cash requirements of the Psychiatric Group and the appropriate use of the proceeds from the February 24, 1999 sale of the RCC investment. Initially, proceeds from the RCC disposition, net of closing costs and applicable reserves, will be retained by the Psychiatric Group to defray its ongoing costs, including the potential long-term costs of carrying the two remaining Psychiatric Group properties. The Psychiatric Group may continue to retain such proceeds or, alternatively, may distribute a portion of such net proceeds to holders of Psychiatric Group Depositary Shares, in cash or Core Group Common Stock, either by dividend or in connection with redemption of the Psychiatric Group Depositary Shares. Should the Board of Directors of the Company decide that the remaining Psychiatric Group portfolio and operations are not consistent with a separate public security, the Board may elect to redeem the outstanding Psychiatric Group Depositary Shares in cash or in exchange for shares of Core Group Common Stock. Under the terms of the Certificate of Designations for the Psychiatric Group Preferred Stock and the Deposit Agreement providing for issuance of Depositary Receipts (Psychiatric Group Depositary Shares) each representing one-tenth of one share of the Psychiatric Group Preferred Stock, the Company has the right to redeem all outstanding Psychiatric Group Depositary Shares, and the Psychiatric Group Preferred Stock represented thereby, for cash (or in exchange for newly issued shares of Core Group Common Stock) at a premium generally ranging from 5% to 15% over the value of the Psychiatric Group Depositary Shares. Since an exchange or redemption of the Psychiatric Group Depositary Shares may be at a premium to the then current market price of the Psychiatric Group Depositary Shares, and since the Board could determine to effect such an exchange or redemption at a time when either or both the Core Group Common Stock and the Psychiatric Group Depositary Shares may be considered to be overvalued or undervalued, the exchange or redemption could be disadvantageous to the holders of the Core Group Common Stock or the Psychiatric Group Depositary Shares.
AMERICAN HEALTH PROPERTIES, INC. AND SUBSIDIARIES
NOTES TO PSYCHIATRIC GROUP COMBINED FINANCIAL STATEMENTS -- (CONTINUED)
QUARTERLY FINANCIAL DATA (UNAUDITED)
- - ---------------
(1) Includes impairment loss of $2,730 on Psychiatric Group notes receivable.
(2) Includes impairment loss of $5,600 on Psychiatric Group real estate and notes receivable.
(3) Includes impairment loss of $11,000 on Psychiatric Group real estate and notes receivable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Englewood, State of Colorado, on the 26th day of March, 1999.
AMERICAN HEALTH PROPERTIES, INC.
By: MICHAEL J. MCGEE
------------------------------------ Michael J. McGee Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Joseph P. Sullivan and Michael J. McGee, and each or either of them as his true and lawful attorney-in-fact and agent, with full power of substitution, for him and in his name, place and stead, in any and all capacities, to sign any or all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
EXHIBIT INDEX