ITEM 1 BUSINESS General
National Health Realty, Inc. (NHR) is a Maryland corporation formed during 1997 and in operation since January 1, 1998. On December 31, 1997, NHR, through its subsidiary NHR/OP, L.P. (the Operating Partnership) acquired ownership of 16 licensed skilled nursing facilities, one 160 bed certificate of need (now sold), six assisted living facilities and one independent living center (the Health Care Facilities). It additionally and simultaneously acquired 50 first and second mortgage secured promissory notes with a then outstanding balance of $94.4 million (the Notes) from its then sole owner National HealthCare L.P. NHR then leased (the Leases) the Healthcare Facilities to National HealthCare Corporation (NHC), a successor by merger to National HealthCare L.P. NHR also assumed certain debt of approximately $86.4 million. During 1998, the Company increased its investment in the Healthcare Facilities by $20,874,000, with a corresponding increase in rental income. The Leases covering the Healthcare Facilities are "triple net" leases. NHR entered into an Advisory, Administrative Services and Facilities Agreement with NHC pursuant to which NHC will provide NHR with investment advice, office space and personnel. This agreement also provides that prior to the earlier to occur of (i) the termination of the Advisory Agreement for any reason and (ii) NHC ceasing to be actively engaged as the investment advisor for National Health Investors, Inc. (NHI), NHR will not (without the prior approval of NHI) transact business with any party, person, company or firm other than NHC. It is the intent of this restriction that NHR will not be actively or passively engaged in the pursuit of additional investment opportunities, but rather will focus upon its capacities as landlord and note holder of those certain assets initially conveyed to it.
NHR's revenues are derived primarily from NHC under the Leases and the interest and principal payments of the Notes. NHC is the manager of all nursing facilities securing the Notes.
Forty-three of the Notes (representing approximately $74.8 million the principal amount and collateralized with 16 nursing facilities) are from Florida Convalescent Centers, Inc. (FCC), and are currently managed by NHC, but may remain outstanding even if NHC is not the manager. The FCC Notes bear interest at 10.25% and are due in 2004; however, the Company anticipates that they will be prepaid, perhaps during 1999. There is no prepayment penalty. NHR will make every effort to reinvest any amounts prepaid. However, if NHR uses the money to reduce existing debt, this will result in a reduction of cash flow which may cause the dividend paid by NHR to remain flat for the near future. The balance of the Notes are secured by seven nursing facilities and seven separate makers and guarantors.
Assumed Liabilities.
NHR assumed approximately $86.4 million of debt from NHC but immediately refinanced approximately $71.6 million from a commercial bank group with Bank of Tokyo, Agent on an overall loan of $75 million. An additional line of credit of $20 million was also made available by this group, all but $4,500,000 of which had been drawn by December 31, 1998. The interest rate on $11.6 million of the remaining Assumed Liabilities include fixed rates of 8.4% and 8.3%. The interest rate on $3.2 million of the remaining Assumed Liabilities is at a variable rate (5.0% at December 31, 1998). The replacement financing and line of credit bear interest at LIBOR plus 1% (one percent). The term of the loans extend through 2011.
Investment and Other Policies of NHR.
General. NHR's investment objectives are: (I) to provide current income for distribution to stockholders, (ii) to provide the opportunity for additional returns to investors by participating in any increase in the operating revenues of its leased properties; (iii) to provide the opportunity to realize capital growth resulting from appreciation, if any, in the value of its portfolio properties, and (iv) to preserve and protect stockholder's capital. There is no assurance that these objectives will be realized.
Advisory Agreement. NHR has contracted for its management with NHC. The NHR Advisory Agreement provides that NHR will not, without the prior approval of NHI, be actively or passively engaged in the pursuit of additional investment opportunities until the earlier of the termination of the Advisory Agreement or such time as NHC is no longer actively engaged as investment advisor to NHI. For its services, NHC is entitled to annual compensation of the greater of 2% of NHR's gross consolidated revenues or the actual expense incurred by NHC. The actual amount paid to NHC in 1998 is $471,000. Either party may terminate the Advisory Agreement on 90 days notice after January 1, 2000, and NHR may terminate at any time for cause.
Objectives and Policies. NHR was organized to own the Healthcare Facilities and Notes. Because of the competitive restrictions contained in the Advisory Agreement, NHR does not intend to seek further health care-related investment opportunities or to provide lease or mortgage financing for such investments. NHR expects to continue to engage in transactions with NHC, but does not anticipate purchasing from, leasing to or financing other operations. Subject to the Advisory Agreement, the Board of Directors may alter NHR's investment policies if they determine in the future that such a change is in the best interests of NHR and its stockholders. The methods of implementing NHR's investment policies may vary as new investment and financing techniques are developed or for other reasons.
NHC Master Agreement to Lease
The Master Agreement to Lease (the "Master Agreement") with NHC regarding the Health Care Facilities, sets forth certain terms and conditions applicable to all leases entered into by and between NHC and the Company (the "Leases"). The Leases are for an initial term expiring on December 31, 2007 with two five year renewal options at the election of NHC which allow for the renewal of the leases on an omnibus basis only. During the initial term and the first renewal term (if applicable), NHC is obligated to pay annual base rent for the respective Health Care Facilities plus additional rent described below. During the second renewal term, NHC is required to pay annual base rent based on the then fair market rental of the property as negotiated at that time between NHC and the Company. In addition, in each year after 1999, NHC is obligated to pay percentage rent to the Company equal to 3% of the amount by which gross revenues of each NHC leased Health Care Facility in such later year exceeds the gross revenues of such Health Care Facility in 1999. Thus, NHC will pay no percentage rent for 1998 or 1999.
The Master Agreement is a "triple net lease", under which NHC is responsible to pay all taxes, utilities, insurance premium costs, repairs (including structural portions of the buildings, constituting a part of the Health Care Facilities) and other charges relating to the ownership and operation of the Health Care Facilities. NHC is obligated at its expense to keep all improvements and fixtures and other components of the Health Care Facilities covered by "all risk" insurance in an amount equal to the full replacement costs thereof, insurance against boiler explosion and similar insurance, flood insurance if the land constituting the Health Care Facility is located within a designated flood plain area and to maintain specified minimal personal injury and property damage insurance, protecting the Company as well as NHC at such Health Care Facility. NHC is also obligated to indemnify and hold harmless the Company from all claims resulting from the use and occupancy of each Health Care Facility by NHC or persons claiming under NHC and related activities, as well as to indemnify the Company against, all costs related to any release, discovery, cleanup and removal of hazardous substances or materials on, or other environmental responsibility with respect to, each Health Care Facility leased by NHC.
Advisory Agreement
The Company entered into the Advisory Agreement with NHC as "Advisor" under which NHC provides management and advisory services to the Company during the term of the Advisory Agreement. The Company believes the Advisory Agreement benefits the Company by providing it access to NHC's extensive experience in the ownership and management of long-term care facilities and retirement centers. Under the Advisory Agreement, the Company engaged NHC to use its best efforts (a) to present to the Company a continuing and suitable investment program consistent with the investment policies of the Company adopted by the Board of Directors from time to time; (b) to manage the day- to-day affairs and operations of the Company; and (c) to provide administrative services and facilities appropriate for such management. In performing its obligations under the Advisory Agreement, NHC is subject to the supervision of and policies established by the Company's Board of Directors.
The Advisory Agreement was initially for a stated term which expires January 1, 2000. The Agreement thereafter is on a year to year term with a 90 day termination period by either party without cause. The Company may terminate the Advisory Agreement for cause at any time. For its services under the Advisory Agreement, the Advisor is entitled to annual compensation of the greater of 2% of NHR's gross consolidated revenues or the actual expense incurred by NHC. The actual amount paid to NHC in 1998 is $471,000. Either party may terminate the Advisory Agreement on 90 days notice after January 1, 2000.
Pursuant to the Advisory Agreement, NHC manages all of the day-to-day affairs of the Company and provides all such services through its personnel. The Advisory Agreement provides that without regard to the amount of compensation received by NHC under the Advisory Agreement, NHC shall pay all expenses in performing its obligations including the employment expenses of the officers and directors and personnel of NHC providing services to the Company. The Advisory Agreement further provides that the Company shall pay the expenses incurred with respect to and allocable to the prudent operation and business of the Company including any fees, salaries, and other employment costs, taxes and expenses paid to directors, officers and employees of the Company who are not also employees of NHC. Currently, other than the directors who are not employees of NHC, the Company does not have any officers or employees who are not also employees of NHC. The Company's three executive officers, Mr. W. Andrew Adams, Mr. Robert G. Adams and Mr. LaRoche are employees of NHC and all of their fees, salaries and employment costs are paid by NHC, although a portion is allocated for their services to NHR.
Federal Income Tax. NHR believes that it has operated its business so as to qualify as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the Code) and NHR intends to continue to operate in such a manner, but no assurance can be given that NHR will be able to qualify at all times. If NHR qualifies as a REIT, it will generally not be subject to federal corporate income taxes on its net income that is currently distributed to its stockholders. This treatment substantially eliminates the "double taxation" (at the corporate and stockholder levels) that typically applies to corporate dividends.
ITEM 2
ITEM 2 PROPERTIES
Healthcare Facilities
The following table includes certain information regarding the Healthcare Facilities, all of which are leased for an initial ten (10) year term to National HealthCare Corporation:
Mortgage Notes. NHR owns approximately 50 Mortgage Notes representing approximately $93.1 million loaned to the owners of approximately 23 nursing homes, all but one of which are in Florida and all of which are currently managed by NHC. The loans were utilized by the owners to acquire land, then construct and equip the nursing homes or to provide working capital. The Mortgage Notes are secured by mortgages on each of the facilities. Forty- three of the Mortgage Notes (representing approximately $73.5 million of the principal amount) are from FCC. The FCC Notes bear interest at 10.25% and are due in 2004. They will remain outstanding during their term even if NHC is not managing the centers. However, the Company anticipates that they may be prepaid as early as 1999. There is no prepayment penalty. NHR will make every effort to reinvest any amounts prepaid. However, if NHR uses the money to reduce existing debt, this will result in a reduction of cash flow which may cause the dividend paid by NHR to remain flat for the near future.
The nursing homes which are located in Florida are each licensed for approximately 120 to 180 beds. No defaults have occurred under any of the Mortgage Notes. NHC has no reason to suspect any impending defaults under the Mortgage Notes.
ITEM 3
ITEM 3 LEGAL PROCEEDINGS
NHR is not subject to any pending litigation. The HealthCare Facilities are subject to claims and suits in the ordinary course of business. NHR's lessees and mortgagees have indemnified and will continue to indemnify NHR against all liabilities arising from the operation of the Health Care Facilities, and will indemnify NHR against environmental or title problems affecting the real estate underlying such facilities. While there are lawsuits pending against certain of the mortgagees and/or lessees of the Health Care Facilities, management believes that the ultimate resolution of all pending proceedings will have no material adverse effect on NHR or its operations.
ITEM 4
ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During 1998 there were no matters submitted to a vote of security holders.
PART II ----------
ITEM 5
ITEM 5 MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
In order to qualify for the beneficial tax treatment accorded to a REIT, the Company must make quarterly distributions to holders of its Common Stock equal on an annual basis to at least 95% of the Company's REIT taxable income (excluding net capital gains), as defined in the Code. Cash available for distribution to stockholders of the Company is primarily derived from interest payments received on its mortgages and from rental payments received under the Company's leases. All distributions will be made by the Company at the discretion of the Board of Directors and will depend on the cash flow and earnings of the Company, its financial condition, bank covenants contained in its financing documents and such other factors as the Board of Directors deems relevant. The Company's REIT taxable income is calculated without reference to its cash flow. Therefore, under certain circumstances, the Company may not have received cash sufficient to pay its required distributions.
The shares are listed on the American Stock Exchange (AMEX) under the symbol "NHR". On February 26, 1999 the last reported sale price for the Common Stock on the AMEX was $11.938. As of December 31, 1998, NHR had approximately 4,482 shareholders, of which approximately 2,282 are holders of record with the balance indicated by security listing positions.
High and low stock prices and dividends for 1998 were:
Cash Sales Price Dividends Quarter Ended High Low Declared ------------- ------ ------ --------- March 31 $21.313 $16.875 .3325 June 30 17.750 14.125 .3325 September 30 15.625 12.875 .3325 December 31 15.125 11.125 .3325
ITEM 6
ITEM 6 SELECTED FINANCIAL DATA
ITEM 7
ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
National Health Realty, Inc. (NHR) is a real estate investment trust that began operations on January 1, 1998. NHR, through its subsidiary NHR/OP, L.P. (the Operating Partnership), acquired ownership of the real estate of 23 health care facilities, including 16 licensed skilled nursing facilities, six assisted living facilities and one independent living center (the Healthcare Facilities), (initial book value of $144,615,000), plus 51 first and second mortgage secured promissory notes with an initial principal balance of $94,439,000 from its then sole owner National HealthCare L.P. NHR then leased the Health Care Facilities to National HealthCare Corporation (NHC), a successor by merger to National HealthCare L.P. NHR also assumed certain debt, initially in the amount of $86,414,000.
Competitive Restrictions--
NHR entered into an advisory services agreement with NHC pursuant to which NHC will provide NHR with investment advice, office space and personnel. This agreement also provides that prior to the earlier to occur of (I) the termination of the advisory agreement for any reason and (ii) NHC ceasing to be actively engaged as the investment advisor for National Health Investors, Inc. (NHI), NHR will not (without the prior approval of NHI) transact business with any party, person, company or firm other than NHC. It is the intent of the foregoing restriction that NHR will not be actively or passively engaged in the pursuit of additional investment opportunities, but rather will focus upon its capacities as landlord and note holder of those certain assets conveyed to it by National HealthCare L.P.
CAPITAL RESOURCES AND LIQUIDITY
The assets of NHR as of December 31, 1998 include mortgage and other notes receivable (book value of $93,099,000) and the real estate of 23 properties, including 16 long-term care centers, six assisted living facilities and one independent living center (total book value of $158,910,000). Long-term debt of $103,628,000 includes a term loan with a principal amount of $90,500,000 which matures in 2002.
Approximately $73,494,000 of the mortgage and other notes receivable is due from Florida Convalescent Centers, Inc. (FCC) of Sarasota, Florida. FCC operates 16 licensed nursing centers that are managed by NHC. NHR is the primary lender to FCC. On October 30, 1998, NHC announced terms of its settlement of litigation with FCC. Under the terms of NHC's settlement with FCC, NHR may receive prepayments without penalty of up to $62,765,000 in notes receivable. NHC is expected to assume the remaining $10,729,000 of notes receivable. NHR will attempt to reinvest any amounts prepaid. Although NHR's existing line of credit requires a portion of the prepayments to be used to reduce bank debt, NHR may seek to obtain a waiver of this requirement. In the event that NHR uses the money to pay down existing debt, it will result in a reduction of cash flow. This could result in dividends remaining constant; however, no dividend reductions are expected in the near future. Under the terms of the settlement, prepayments may be made at any time.
FCC may also elect to terminate its management contract with NHC prior to repaying its notes owed to NHR. In this event, NHR's assets will no longer be solely managed by NHC.
Sources and Uses of Funds--
NHR's leasing and mortgage services generated net cash from operating activities during 1998 in the amount of $14,955,000. The funds were used along with $15,500,000 of proceeds from long-term debt and $1,340,000 from the collections of mortgage loans receivable to fund acquisitions of property and equipment in the amount of $20,874,000, to repay long-term debt of $1,727,000 and to pay dividends to stockholders of $9,371,000.
NHR is leasing each of the 23 facilities to NHC. Each lease is for an initial term expiring December 31, 2007, with two additional five year renewal terms at the option of NHC, assuming no defaults. NHR accounts for its leases as operating leases.
During the initial term and each renewal term, NHC is obligated to pay NHR annual base rent (commencing for each center when construction is complete) on the 23 facilities of $15,449,000. In addition to base rent, in each year after 1999, NHC must pay percentage rent to NHR equal to 3% of the amount by which gross revenues of each facility in such later year exceed the gross revenues of such facility in 1999. Each lease is a "triple net lease" under which NHC is responsible for paying all taxes, utilities, insurance premium costs, repairs and other charges relating to the operation of the facilities.
NHR has entered into an advisory services agreement with NHC whereby the services related to investment activities and day-to-day management and operations are provided to NHR by NHC. Because of the competitive restrictions contained in the advisory services agreement, NHR does not intend to seek further health care-related investment opportunities or to provide lease or mortgage financing for such investments with operations other than NHC but expects to continue to engage in the existing transactions with NHC and potentially new investments.
Commitments--
NHR intends to pay quarterly distributions to its stockholders in an amount at least sufficient to satisfy the distribution requirements of a real estate investment trust. Such requirements necessitate that at least 95% of NHR's taxable income be distributed annually. The primary source for distributions will be rental and interest income NHR earns on the real property and mortgage notes receivable transferred to it by NHC. Dividends in the amount of $1.33 per share were declared for payment during 1998.
Certain of the real properties transferred by NHC to NHR remain under construction at December 31, 1998. NHC will complete the construction of these properties and, upon completion of the construction, NHR will purchase the additional constructed assets from NHC.
At year end, NHR's long-term debt as a percentage of total liabilities and capital was 40.6%. The amount available to be drawn on NHR's $95.0 million term loan was $4.5 million at December 31, 1998. NHR's cash on hand, its operating and investing cash flows, and, as necessary, its borrowing capacity are expected to be adequate to fund the purchase of the constructed assets as well as to repay borrowings at or prior to their maturity.
RESULTS OF OPERATIONS
Year Ended December 31, 1998-
Net income for the year was $8,267,000 or 89 cents per share, basic, and 87 cents per share, diluted.
The significant components of revenue for the first year of NHR's operations are rental income (57.6% of revenues) and mortgage interest income (41.4% of revenues).
The significant components of expenses for this first year of operations are interest (48.8% of total expenses) and depreciation of real estate(46.5% of total expenses).
The rental income revenues are believed by management to be secure. However, all of the rental income is from NHC, NHR's sole lessee. Approximately 60% of NHC's revenues are from participation in the Medicare and Medicaid programs. During 1997, the federal government enacted the Balanced Budget Act of 1997 (BBA) which contains numerous Medicare and Medicaid cost- saving measures. As part of these cost-saving measures, the BBA requires that nursing homes transition to a prospective payment system over a three cost report year transition period. The BBA also contains certain measures which have or will lead to reductions in Medicare payments for home health agency services and therapy services. Furthermore, NHC has stated in its financial statements that it is a defendant in a lawsuit filed under the Qui Tam provisions of the Federal False Claims Act. NHR is unable to predict the ultimate effect the enactment of the BBA or the pending lawsuit will have on NHC's ability to make its lease payments to NHR.
The mortgage interest income revenues are also believed by management to be secure. However, the mortgages are with five different owners and are secured with the property of 23 long-term health care centers located in two states, all of which are currently managed by NHC. The revenues of the 23 health care centers are subject to the cost-saving measures of the BBA. NHR is unable to predict the ultimate effect the enactment of the BBA will have on the ability of the 23 health care centers to make their debt service payments to NHR.
IMPACT OF INFLATION
Inflation may affect NHR in the future by changing the underlying value of NHR's real estate or by impacting NHR's cost of financing its operations.
Revenues of NHR are primarily from long-term investments. NHR's leases with NHC require increases in rent income based on increases in the revenues of the leased facilities.
YEAR 2000 COMPLIANCE
NHR has evaluated its information technology systems and embedded technology with respect to potential Year 2000 problems. Although management believes that the majority of NHR's information technology systems and embedded technology is already Year 2000 compliant, NHR will complete the testing of its information technology systems and embedded technology in the third quarter of 1999. In addition, NHR has developed corrective plans for any technology assessed to be non-compliant.
As a result of its advisory agreement with NHC, NHR is reliant upon NHC for much of its information technology systems and embedded technology. NHC has performed an evaluation of its information technology as it relates to NHR. Although NHR believes that the majority of NHC's information technology systems and embedded technology is already Year 2000 compliant, NHC will complete the testing of its information technology systems and embedded technology in the third quarter of 1999. NHR believes that NHC has developed corrective plans for any technology assessed to be non-compliant.
Costs incurred to date for NHR's internal Year 2000 remediation efforts have not been material, and NHR does not expect that the cost of future internal actions will be material to its financial condition or results of operations.
Based upon current information, NHR anticipates successful completion and testing of its Year 2000 remediation efforts during 1999. However, there can be no guarantee that the Year 2000 will not have a material adverse effect on NHR's operations, financial position or liquidity if NHR's remediation efforts are not successful or completed in a timely manner. NHR is currently developing a contingency plan in the event that it is not able to achieve Year 2000 compliance. This contingency plan is expected to include identifying back-up processes that do not rely on computers, whenever possible.
However, NHR also depends upon the proper functioning of information technology systems and embedded technology operated by certain other third parties. These third parties include lessors and debtors that participate in the Medicare and Medicaid programs, commercial banks and other lenders, and vendors such as telecommunications and utilities providers. NHR is currently evaluating and obtaining information concerning the Year 2000 compliance status of these third parties. If third parties have Year 2000 problems that are not remedied, the following problems could result: (i) in the case of lessors and debtors that rely on third party payors, in delayed collection of rent, mortgage notes and interest payments; (ii) in the case of banks and other lenders, in the disruption of capital flows potentially resulting in liquidity stress; or (iii) in the case of vendors, in disruption of important services upon which NHR depends, such as telecommunications and electrical power.
ITEM 7A
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Interest Rate Risk
The Company's cash and cash equivalents consist of highly liquid investments with a maturity of less than three months. All of the Company's mortgage and other notes receivable bear interest at fixed interest rates. As a result of the short-term nature of the Company's cash instruments and because the interest rates on the Company's investment in notes receivable are fixed, a hypothetical 10% change in interest rates has no impact on the Company's future earnings and cash flows related to these instruments. A hypothetical 10% change in interest rates has an immaterial impact on the fair values of these instruments.
As of December 31, 1998, $93,700,000 of the Company's long-term debt bears interest at floating interest rates. Because the interest rates of these instruments are variable, a hypothetical 10% increase in interest rates would result in additional interest expense of $937,000 and likewise, a 10% reduction in interest rates would result in interest expense declining $937,000. A hypothetical 10% change in interest rates would not have a material impact on the fair values of these instruments. The remaining $9,928,000 of the Company's long-term debt bears interest at fixed rates. A hypothetical 10% change in interest rates has an immaterial impact on the fair values of these instruments.
The Company currently does not use any derivative instruments to hedge its interest rate expense. The Company does not use derivative instruments for trading purposes and the use of such instruments would be subject to strict approvals by the Company's senior officers. Therefore, the Company's exposure related to such derivative instruments is not material to the Company's financial position, results of operations or cash flows.
ITEM 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To National Health Realty, Inc.:
We have audited the accompanying consolidated balance sheets of NATIONAL HEALTH REALTY, INC. (a Maryland corporation) and subsidiaries as of December 31, 1998 and 1997, the related consolidated statements of income, stockholders' equity and cash flows for the year ended December 31, 1998 and the consolidated statement of cash flows for the 97 days ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of National Health Realty, Inc. and subsidiaries as of December 31, 1998 and 1997, the results of their operations and their cash flows for the year ended December 31, 1998 and the results of their cash flows for the 97 days ended December 31, 1997, in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Nashville, Tennessee January 13, 1999
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements.
The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements.
The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements.
The accompanying notes to consolidated financial statements are an integral part of these consolidated financial statements.
NATIONAL HEALTH REALTY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 1. ORGANIZATION
National Health Realty, Inc. (NHR) is a Maryland real estate investment trust (REIT) that was incorporated on September 26, 1997. NHR originally issued 1,000 shares of common stock to National HealthCare Corporation (NHC and formerly National HealthCare L.P.) for $1,000 cash on October 15, 1997. At December 31, 1997, the 1,000 shares issued to NHC were canceled and NHR refunded the $1,000 cash to NHC. NHR had no operations from the date of incorporation through December 31, 1997.
At December 31, 1997, NHC transferred certain assets and liabilities to NHR and NHR/OP, L.P. in exchange for 8,237,423 shares of NHR common stock and 1,310,194 limited partnership units of NHR/OP, L.P. NHC then distributed the common stock of NHR and the limited partnership units of NHR/OP, L.P. to NHC's unitholders at the rate of one share or one unit for each NHC unit outstanding on the record date of December 31, 1997. The limited partnership units of NHR/OP, L.P. were distributed to certain NHC unitholders in order to protect the REIT status of NHR. NHR/OP, L.P. is a Delaware limited partnership that is the operating entity of NHR and is 88% owned by NHR. NHR and NHR/OP, L.P. are collectively referred to herein as "NHR".
The majority of NHR's revenue is derived from interest income on mortgage loans and from rent generated on leased properties.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation - The consolidated financial statements include the accounts of NHR and its majority owned subsidiaries. Significant intercompany accounts and transactions have been eliminated.
Use of Estimates - 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.
Real Estate Properties - NHR records properties at cost, including capitalized interest during construction periods. Real property transferred from NHC was recorded at NHC's net book value at the date of transfer. NHR uses the straight-line method of depreciation for buildings and improvements over their estimated remaining useful lives of up to 40 years.
In accordance with Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" (SFAS 121), NHR evaluates the recoverability of the carrying values of its properties on a property by property basis.
Cash Equivalents - Cash equivalents consist of all highly liquid investments with a maturity of three months or less.
Federal Income Taxes - NHR intends at all times to qualify as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended. Therefore, NHR will not be subject to federal income tax provided it distributes at least 95% of its annual real estate investment trust taxable income to its stockholders and meets other requirements to continue to qualify as a real estate investment trust. Accordingly, no provision for federal income taxes has been made in the consolidated financial statements.
The primary difference between NHR's tax basis and the reported amounts of NHR's assets and liabilities is a higher tax basis than book basis (by approximately $8,443,000) in its real estate properties.
Earnings and profits, which determine the taxability of dividends to stockholders, differ from net income reported for financial reporting purposes due primarily to differences in the basis of assets and differences in the estimated useful lives used to compute depreciation expense.
Concentration of Credit Risks - NHR's credit risks primarily relate to cash and cash equivalents and to the investments in mortgage and other notes receivable. Cash and cash equivalents are primarily held in bank accounts and overnight investments. The investments in mortgage and other notes receivable relate primarily to secured loans with health care facilities as discussed in Note 5.
NHR's financial instruments, principally its investments in mortgage and other notes receivable, are subject to the possibility of loss of the carrying values as a result of either the failure of other parties to perform according to their contractual obligations or changes in market prices which may make the instruments less valuable. NHR obtains various collateral and other protective rights, and continually monitors these rights, in order to reduce such possibilities of loss. NHR evaluates the need to provide for reserves for potential losses on its financial instruments based on management's periodic review of its portfolio on an instrument by instrument basis.
Deferred Costs - Costs incurred to acquire financings are amortized by the interest method over the term of the related debt.
Rental Income - Rental income is recognized by NHR based on the terms of NHR's leases.
Mortgage Interest Income - Mortgage interest income is recognized by NHR based on the interest rates and principal amounts outstanding of the mortgage notes receivable.
NOTE 3. RELATIONSHIP WITH NATIONAL HEALTHCARE CORPORATION
Transfer of Assets - On December 31, 1997, NHR issued 8,237,423 shares of NHR common stock and 1,310,194 units of NHR/OP, L.P. to NHC in exchange for certain assets including mortgage notes receivable (book value of $94,439,000) and the real property of 16 long-term care centers, six assisted living facilities and one retirement center (total book value of $144,615,000) and related liabilities (total book value of $86,414,000). NHC simultaneously distributed the common stock of NHR and NHR/OP, L.P. units to the NHC unitholders.
Leases - Concurrent with NHC's conveyance of the real property to NHR, NHR leased to NHC each of the 23 facilities. Each lease is for an initial term expiring December 31, 2007, with two additional five year renewal terms at the option of NHC, assuming no defaults. NHR accounts for the leases as operating leases.
During the initial term and each renewal term, NHC is obligated to pay NHR annual base rent on the 23 facilities. In addition to base rent, in each year after 1999, NHC must pay percentage rent to NHR equal to 3% of the amount by which gross revenues of each facility in such later year exceed the gross revenues of such facility in 1999. Each lease with NHR is a "triple net lease" under which NHC is responsible for paying all taxes, utilities, insurance premium costs, repairs and other charges relating to the operation of the facilities. NHC is obligated at its expense to maintain adequate insurance on the facilities' assets. Rental income from NHC was $13,570,000 during 1998.
NHC has a right of first refusal with NHR to purchase any of the properties transferred from NHC should NHR receive an offer from an unrelated party during the term of the lease or up to 180 days after termination of the related lease.
At December 31, 1998, the approximate future minimum base rent commitments to be received by NHR on non-cancelable operating leases with NHC are as follows:
1999 $15,485,000 2000 15,485,000 2001 15,485,000 2002 15,485,000 2003 15,485,000 Thereafter 61,940,000
Tax Treatment of the Transfer - The transfer of assets was treated as a nontaxable exchange under Section 351 of the Internal Revenue Code of 1986, as amended. For federal income tax purposes, no gain or loss was recognized by NHC or by its unitholders upon the transfer of assets to NHR or upon the distribution of the shares of NHR. The tax basis of shares of NHR received by NHC unitholders in the distribution was $16.54 per share for most unitholders.
Advisory Agreement - NHR has entered into an Advisory Agreement with NHC whereby services related to investment activities and day-to-day management and operations are provided to NHR by NHC as Advisor. The Advisor is subject to the supervision of and policies established by NHR's Board of Directors.
Either party may terminate the Advisory Agreement on 90 days notice at any time after January 1, 2000. NHR may terminate the Advisory Agreement for cause at any time.
For its services under the Advisory Agreement, NHC is entitled to annual compensation of the greater of 2% of NHR's gross consolidated revenues or the actual expenses incurred by NHC. During 1998, NHR's compensation to NHC under the Advisory Agreement was $471,000.
NHC is also the Advisor of National Health Investors, Inc. (NHI). Pursuant to the NHR Advisory Agreement, NHR has agreed that as long as NHC is obligated both under the NHR Advisory Agreement and the NHI Advisory Agreement, NHR will only do business with NHC and will not compete with NHI. As a result, NHR is severely limited in its ability to grow and expand its business. Furthermore, NHR will not seek additional investments to expand its investment portfolio.
NOTE 4. REAL ESTATE PROPERTIES
The following table summarizes NHR's real estate properties by type of facility and by state as of December 31, 1998:
NOTE 5. MORTGAGE AND OTHER NOTES RECEIVABLE
The following is a summary of the terms and amounts of mortgage notes receivable at December 31, 1998: (Dollar amounts in thousands)
Approximately $73,494,000 of the mortgage and other notes receivable is due from Florida Convalescent Centers, Inc. (FCC) of Sarasota, Florida. FCC operates 16 licensed nursing centers that are managed by NHC. NHR is the primary lender to FCC. On October 30, 1998, NHC announced terms of its settlement of litigation with FCC. Under the terms of NHC's settlement with FCC, NHR may receive prepayments of up to $62,765,000 in notes receivable from FCC, and NHC is expected to assume the remaining $10,729,000. NHR will attempt to reinvest any amounts prepaid. Although NHR's existing line of credit requires a portion of the prepayments to be used to reduce bank debt, NHR may seek to obtain a waiver of this requirement. In the event that NHR uses the money to pay down existing debt, it will result in a reduction of cash flow. Under the terms of the settlement, prepayment may be made at any time.
In the opinion of management, NHR maintains adequate collateral, including first and second mortgages, certificates of need, personal guarantees and stock pledges on its mortgage notes receivable. Management continually monitors the status of its debtors and evaluates the recoverability of its mortgage and other notes receivable on an instrument by instrument basis.
NOTE 6. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:
Mortgage and other notes receivable - The fair value of NHR's mortgage and other notes receivable is estimated based on the current rates offered by NHR and other real estate investment trusts and financial institutions for the same or similar types of mortgage and other notes receivable of the same or similar maturities.
Interest and rent receivable - The carrying amount approximates the fair value because of the short term nature of these receivables.
Cash and cash equivalents - The carrying amount approximates fair value because of the short maturity of these instruments.
Long-term debt - The fair value of NHR's long-term debt is estimated based on the current rates offered to NHR and other real estate investment trusts for debt of the same remaining maturities.
The estimated fair values of NHR's financial instruments are as follows:
NOTE 7. LONG-TERM DEBT
Long-term debt consists of the following:
On December 31, 1997, NHR used proceeds from the term loan to repay debt transferred from NHC in the approximate amount of $71,559,000.
The aggregate principal maturities of all long-term debt for the five years subsequent to December 31, 1998 are as follows:
1999 $ 1,727,000 2000 5,476,000 2001 5,476,000 2002 84,727,000 2003 1,294,000
Substantially all real estate property and certain mortgage and other notes receivable are pledged as collateral on the long-term debt.
Certain loan agreements require maintenance of specified operating ratios and stockholders' equity by NHR. All such covenants have been met by NHR.
NOTE 8. COMMITMENTS, CONTINGENCIES AND GUARANTEES
Certain of the real property transferred by NHC to NHR remains under development at December 31, 1998. NHC will complete the construction of these properties and, upon completion of the construction, NHR is committed to purchase the constructed assets from NHC. NHR's cash on hand, its operating and investing cash flows, and, as needed, its borrowing capacity are expected to be adequate to fund these commitments.
At December 31,1998, NHR is obligated to issue at the election of the holders 20,000 shares of its common stock related to stock options (the NHC Options) originally issued by NHC and 46,954 shares of its common stock related to the conversion of certain 6% senior subordinated convertible notes (the NHC Notes) issued by NHC. The NHC Notes are the obligation of NHC and mature July 1, 2000. The NHC Options are exercisable and the NHC Notes are convertible at the election of the holders into an equal number of shares of the common stock of NHC and NHR. Thus, NHR is obligated to issue NHR common stock upon the exercise of the NHC Options and conversion of the NHC Notes. NHR will receive no proceeds from the exercise of the NHC Options and the conversion of the NHC Notes. NHR has reserved an additional 66,954 shares of common stock for the exercise of the NHC options and the conversion of the NHC Notes.
At December 31, 1997, in order to protect the REIT status of NHR, certain NHC unitholders received limited partnership units of NHR/OP, L.P. rather than shares of common stock of NHR. As a result of certain unitholders' involuntary acceptance of NHR/OP, L.P. partnership units to benefit all other unitholders, NHR has indemnified those certain unitholders for any tax consequence resulting from any involuntary conversion of NHR/OP, L.P. partnership units into shares of NHR common stock. The indemnification expires at such time as the NHR/OP, L.P. unitholders are in a position to voluntarily convert their partnership units into NHR common stock on a tax free basis without violating applicable REIT requirements.
NOTE 9. STOCK OPTION PLAN
The Board of Directors of NHR has approved the 1997 Stock Option and Appreciation Rights Plan under which options to purchase shares of NHR's common stock are available for grant to consultants, advisors, directors and employees of NHR at a price no less than the market value of the stock on the date the option is granted.
At December 31, 1998, NHR has granted options to directors to purchase 15,000 shares of NHR common stock at $18.88 per share. During the twelve months ended December 31, 1998, no options to purchase shares of NHR were exercised. NHR has reserved 485,000 shares of common stock for issuances under the NHR stock option plan.
NHR has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation" (SFAS 123). As a result no compensation cost has been recognized for NHR's stock option plans. Based on the number of options granted and the historical and expected future trends of factors affecting valuation of those options, management believes that the additional compensation cost, as calculated in accordance with SFAS 123, has no effect on NHI's pro forma earnings and earnings per share.
NOTE 10. EARNINGS PER SHARE
NHR has calculated earnings per share in accordance with Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS 128). Basic earnings per share is based on net income as reported in the consolidated statement of income and the weighted average number of common shares outstanding during the year.
Diluted earnings per share assumes the conversion of the NHC Notes into NHR common stock and the exercise of the NHC Options into shares of NHR common stock using the treasury stock method. Because NHR will receive no proceeds from the conversion of the NHC Notes and the exercise of NHC Options, for purposes of calculating diluted earnings per share, there is no adjustment to net income as reported in the consolidated statement of income.
NOTE 11. LIMITS ON COMMON STOCK OWNERSHIP
NHR's Articles of Incorporation limit the percentage of ownership that any person may have in the outstanding common stock of NHR to 9.8% of the aggregate of the outstanding stock. This limit is necessary in order to reduce the possibility of NHR's failing to meet the stock ownership requirements for REIT qualification under the Internal Revenue Code of 1986, as amended.
NOTE 12. DIVIDENDS
Dividend payments by NHI to its common stockholders are characterized in the following manner for tax purposes in 1998:
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
PART III
ITEM 10
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
Directors and Executive Officers
The Board of Directors is divided into three classes. Directors will hold office until the annual meeting for the year in which their term expires and until their successor is elected and qualified. As each of their terms expire, the successor shall be elected to a three-year term. A director may be removed from office for cause only. Officers serve at the pleasure of the Board of Directors for a term of one year. The following table sets forth the initial directors and executive officers of NHR:
Each of the directors of NHR are currently directors of National HealthCare Corporation. Mr. W. Andrew Adams and Mr. LaRoche are directors of National Health Investors, Inc. Messrs. Adams and Mr. LaRoche are executive officers not only of NHR, but in similar capacities with NHC and NHI.
Drs. Twilla and Williams have been physicians in private practice in Tennessee for more than 25 years each and are now retired. Dr. Williams is now serving on the Board of the Bank of Murfreesboro, headquartered in Murfreesboro, Tennessee.
Mr. W. Andrew Adams is the President and a Director of the Company and has been the Chief Executive Officer of NHC since 1981, and on its Board since 1974. He currently serves on the Multi-facility Committee of the American Health Care Association. He has an M.B.A. degree from Middle Tennessee State University. Mr. Adams serves on the Board of Trust of David Lipscomb University, Nashville, Tennessee, is President and Chairman of the Board of Directors of National Health Investors, Inc. and National HealthCare Corporation and serves on the Board of SunTrust Bank in Nashville, Tennessee.
Mr. Robert Adams is Senior Vice President and a Director of the Company and also serves in those positions for NHC. He has a B.S. degree from Middle Tennessee State University. He is Chief Operating Officer for NHC. He is responsible for operations in Alabama, Indiana, Kentucky, Missouri, Tennessee, and parts of Florida, the Company's home infusion subsidiary, and all construction.
Mr. Burgess (Director) is a retired Senior Vice President of NHC. He has an M.S. degree from the University of Tennessee.
Mr. LaRoche is Senior Vice President and Secretary of the Company and has also served in those positions for NHC since 1974 and as General Counsel since 1971. He has a law degree from Vanderbilt University and an A.B. degree from Dartmouth College. His responsibilities include legal affairs, acquisitions and finance. Mr. LaRoche also serves as a Director, Vice President and Secretary of National Health Investors, Inc.
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
Outside directors receive $2,500 per meeting attended. All directors attended all three board meetings in 1998. In addition, outside directors receive an automatic stock option to each purchase 5,000 shares of NHR common stock at a purchase price equal to the closing price of the Shares on the date of NHR's annual meeting, presently scheduled for April 26, 1999.
NHR's day to day operations are conducted by personnel provided by NHC. NHR has three executive officers, W. Andrew Adams as President, Robert G. Adams as Vice President and Richard F. LaRoche, Jr., as Vice President and Secretary, all of whom are also officers of NHC and NHI. These three executive officers may receive a bonus for their work for NHR, which is paid by NHC and credited against the advisory fee; however, no bonus as yet has been declared or paid to them for 1998.
The following Table I sets forth certain information concerning the compensation of the Company's chief executive officer and the other executive officers of the Company:
Stock Option Plan
The NHR Board of Directors and the initial sole shareholder of NHR approved the adoption of the 1997 Stock Option and Stock Appreciation Rights Plan (the NHR Stock Option Plan), under which options to purchase shares of NHR's common stock are available for grant to consultants, advisors, directors and employees of NHR, providing an equity interest in NHR and additional compensation based on appreciation of the value of such stock.
The NHR Stock Option Plan allows for options to purchase in the aggregate up to 500,000 shares of common stock to be granted by the NHR Board of Directors. The NHR Board of Directors may, in its discretion grant incentive stock options (ISO's), non-qualified stock options or stock appreciation rights (SAR's)
In addition, the NHR Stock Option Plan provides that the non-employee directors will receive a non-qualified stock option to purchase 5,000 shares of common stock at a purchase price equal to the closing price of NHR Shares on the initial date of trading and will be automatically granted an option to purchase 5,000 shares of common stock annually on the date of NHR's annual meeting with an exercise price equal to the closing price on the date of such annual meeting. All such options shall have a term equal to the first to occur of the following: I) five years from the date of grant or ii) December 31, 2007.
The NHR Stock Option Plan provides that the exercise price of an ISO option must not be less than the fair market value of NHR common stock on the trading day next preceding the date of the grant. Payment for shares of NHR common stock to be issued upon exercise of an option may be made either in cash, NHR common stock or any combination thereof, at the discretion of the option holder. Options are nontransferable, other than by will, the laws of descent and distribution or pursuant to certain domestic relations orders. NHR common stock subject to options granted under the NHR Stock Option Plan that expire, terminate or are canceled without having been exercised in full become available again for option grants.
The NHR Stock Option Plan is administered by the NHR Board of Directors, or, at the discretion of the NHR Board of Directors, a committee of directors. Subject to certain limitations, the NHR Board and its committee have the authority to determine the recipients, as well as the exercise prices, exercise periods, length and other terms of stock options granted pursuant to the NHR Stock Option Plan. In making such determinations, the NHR Board may take into account the nature of the services rendered or to be rendered by option recipients, and their past, present or potential contributions to NHR.
The number of shares of common stock that may be granted under the NHR Stock Option Plan or under any outstanding options granted thereunder will be proportionately adjusted, to the nearest whole share, in the event of any stock dividend, stock split, share combination or similar recapitalization involving NHR common stock or any spin-off, spin-out or other significant distribution of NHR's assets to its stockholders for which NHR receives no consideration.
Generally, in the event an option holder is terminated as an employee by reason of disability or death, the holder or his or her representative may exercise the option for a period of 12 months following such termination unless the Board of Directors elects, in its sole discretion, to extend the exercise period. If the employment of an option holder is terminated for "cause," as defined in the NHR Stock Option Plan, the unexercised options expire. In the event the option holder is terminated as an employee for any reason other than disability, death or cause, the holder may exercise his or her option for a period of three months following termination, unless extended by agreement of NHR.
In the event of a dissolution or liquidation of NHR or a merger or consolidation or acquisition in which NHR is not the surviving corporation, each outstanding option will become fully exercisable and each holder will have the right, within 60 days prior to such dissolution, liquidation, merger, consolidation or acquisition, to exercise his or her options, in whole or in part.
Either non-qualified or incentive stock options may be granted under the NHR Stock Option Plan. No federal income tax consequences occur to either NHR or the optionee upon NHR's grant or issuance of a non-qualified stock option. Upon an optionee's exercise of a non-qualified stock option, the optionee will recognize ordinary income in an amount equal to the difference between the fair market value of NHR common stock purchased pursuant to the exercise of the option and the exercise price of the option. However, if NHR common stock purchased upon exercise of the option is not transferable or is subject to a substantial risk of forfeiture, then the optionee will not recognize income until the stock becomes transferable or is no longer subject to such a risk of forfeiture (unless the optionee makes an election under Internal Revenue Code Section 83(b) to recognize the income in the year of exercise, which election must be made within 30 days of the option exercise). NHR will be entitled to a deduction in an amount equal to the ordinary income recognized by the optionee in the year in which such income is recognized by the optionee. Upon a subsequent disposition of the shares of NHR common stock, the optionee will recognize a capital gain to the extent the sales proceeds exceed the optionee's cost of the shares plus the previously recognized ordinary income.
Incentive stock options granted under the NHR Stock Option Plan are intended to qualify for a favorable tax treatment under Internal Revenue Code Section 422. No individual may be granted incentive stock options under the NHR Stock Option Plan exercisable for the first time during any calendar year and having an aggregate fair market value in excess of $100,000. If the recipient of an incentive stock option disposes of the underlying shares before the end of certain holding periods (essentially the later of one year after the exercise date or two years after the grant date), he or she will generally recognize ordinary income in the year of disposition in an amount equal to the difference between his or her purchase price and the fair market value of NHR common stock on the exercise date. If a disposition does not occur until after the expiration of the holding periods, the recipient will generally recognize a capital gain equal to the excess of the disposition price over the price paid by the recipient on the exercise date. NHR generally will not be entitled to a tax deduction for compensation expense on account of the original sales to employees, but may be entitled to a deduction if a participant disposes of stock received upon exercise of an incentive stock option under the NHR Stock Option Plan prior to the expiration of the holding periods.
The only options which have been granted under the NHR Stock Option Plan to date are the automatic options to purchase 5,000 shares of common stock granted to non-employee directors on the first trading date in 1998, which was January 5, 1998 at $18.875.
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Assumed Liabilities
NHR was transferred the Healthcare Facilities subject to Assumed Liabilities of approximately $86.4 million at December 31, 1997. NHR immediately repaid $71.6 million of the Assumed Liabilities with the proceeds of the NHR Credit Agreement in the amount of $75 million with the Bank of Tokyo/Mitsubishi as Agent. The balance of the Assumed Liabilities includes $11.6 million of secured liabilities at fixed rates of 8.4% and 8.3%, which are amortizing and will be paid in full by the end of the calendar year 2005 and $3.2 million of first mortgage revenue bonds at variable rates (5.0% at December 31, 1998) due in 2011.
Although NHR is subject to the Assumed Liabilities, NHI and NHC will remain liable on certain unassumed portions of such debt in certain percentages. NHR has agreed to indemnify NHC and NHI in respect of such continuing liability.
Of the Assumed Liabilities, approximately $11.6 million is represented by fixed rate first mortgage notes and $3.2 million is represented by variable rate first mortgage revenue bonds on several of the Healthcare Facilities. NHR has obtained the consent of the holders of these notes who have agreed that NHR's liability is limited to (1) its interest in the Healthcare Facilities upon which the mortgages are placed, and (2) further limited to 28% of the total outstanding mortgage notes in question which are cross collateralized with other debt of NHC and NHI.
The Leases
The Master Lease Agreement with NHC provides that each Lease will be for an initial term expiring on December 31, 2007 (the Initial Term). Provided that NHC is not then in default and gives at least six months notice, NHC has the option to renew all (but without NHR's consent not less than all) of the Leases for a further five-year term expiring December 31, 2012 (the First Renewal Term); and, provided that NHC is not then in default and gives at least six (6) months notice, NHC will have the option to renew all (but not less than all) of the Leases for a term expiring December 31, 2017 (the Second Renewal Term).
During the Initial Term and both Renewal Terms (if applicable), NHC is obligated to pay NHR annual base rent for the respective Healthcare Facilities in the respective amounts which upon completion of construction will initially aggregate $15,494,437, increased each year by 3% of the increase in gross revenues over 1999, the "base year."
The Master Agreement and the respective Leases will also obligate NHC to pay as "other additional rent" all real estate taxes, utility charges and other charges imposed by third parties and which, if not paid, might become a levy or a lien upon the property. In addition to the base rent, and other additional rent, in each year after 1999 NHC must pay percentage rent equal to 3% of the amount by which gross revenues of each Healthcare Facility in such later year exceeds the gross revenues of such Healthcare Facility in 1999. Base rent, other additional rent and percentage rent are collectively referred to in the Master Agreement as "rent."
Each Lease of a Healthcare Facility is what is commonly known as a "triple net lease" or "absolute net lease," under which NHC is responsible for paying all taxes, utilities, insurance premium costs, repairs (including to structural portions of the buildings constituting a part of the Healthcare Facilities) and other charges relating to the ownership and operation of the Healthcare Facilities. NHC is obligated at its expense to keep all improvements and fixtures and other components of the Healthcare Facilities covered by "all risk" insurance in an amount equal to at least 100% of the full replacement costs thereof, and insured against boiler explosion and similar insurance; to provide loss of rent insurance (if the same is available at a reasonable cost), and flood insurance if the land constituting the Healthcare Facility is located within a designated flood plain area; and to maintain specified minimal personal injury and property damage insurance, protecting NHR as well as NHC at each Healthcare Facility. NHC is also obligated to indemnify and hold harmless NHR from all claims resulting from the use and occupancy of each Healthcare Facility by NHC or persons claiming under NHC and related activities, as well as to be fully responsible for, and to indemnify and hold NHR harmless against, all costs related to any hazardous substances or materials on, or other environmental responsibility with respect to, each Healthcare Facility.
Under each Lease, NHC's use of the Healthcare Facility is limited to use as a nursing home, healthcare facility or other purpose for which the Leased Property is being used at the commencement date of the Lease unless NHR's consent to some other use is obtained. NHC has responsibility to obtain and maintain all licenses, certificates and consents needed to use and operate each Healthcare Facility for such purposes, and to use and maintain each Healthcare Facility in a careful, safe and proper manner and in compliance with all local board of health and other applicable governmental and insurance regulations. Each Lease permits NHC to replace fixtures at each Healthcare Facility and to finance such replacement (subject to the approval of NHR in the case of any financing in excess of $10,000), and to make alterations with respect to any Healthcare Facility (subject to NHR's approval for any alteration in excess of $150,000 at any one Healthcare Facility in any one year), with the title to any such replacement fixtures and alterations belonging to NHR.
An "Event of Default" will be deemed to have occurred under the Master Agreement and any individual Lease if NHC fails to pay Rent within ten business days after notice of nonpayment; if NHR gives three or more notices of nonpayment of Rent in any one year (provided however that such will not be an Event of Default if NHR fails to exercise its remedies within 60 days after the last of such notices); if NHC fails to perform any other covenant and NHC does not diligently undertake to cure the same within 30 days' notice from NHR; with respect to a Lease of any particular Healthcare Facility, if NHC ceases operations thereof for more than 180 days other than as a result of destruction or condemnation; if any bankruptcy proceedings are instituted by or against NHC and, if against NHC, they are not dismissed within 90 days; if a custodian or receiver is appointed for any Healthcare Facility and not discharged within 60 days or NHC is enjoined or prevented from conducting a substantial part of its business for more than 60 days; if uncontested liens on any part of the property of NHC are not dismissed or bonded within 60 days; or if NHC or any affiliate of NHC defaults on any other material obligation to NHR or on any material obligation under any debt associated with any Healthcare Facility or any debt co-guaranteed by NHR and NHC.
In the event of any Event of Default, NHR may evict NHC and either terminate the Lease or re-let the premise. In either event, NHC shall remain responsible for the rental value of the premises for the stated remainder period of the term in excess of rents received by NHR from any successor occupant. In addition, NHR may exercise any other rights that it may have under law.
In the event of any damage or destruction to any Healthcare Facility, NHC has the obligation to fully repair or restore the same at its expense, with the Base Rent, real estate taxes and other impositions on the particular Healthcare Facility being appropriately abated during the time of restoration. If any Healthcare Facility is damaged to such an extent that 50% of the licensed nursing home beds at such Healthcare Facility are rendered unusable and if NHC has fully complied with the insurance obligations with respect to such Healthcare Facility (including maintaining insurance against loss of rents), NHC may upon turning over all insurance proceeds with respect to such Healthcare Facility terminate the Lease of that Healthcare Facility.
In the event of a condemnation or taking of any leased Healthcare Facility, the Lease terminates as to the portion of the Healthcare Facility taken, and in the event of a partial taking, NHC is obligated to repair the portion not taken, if the same may still be economically used, and the Base Rent therefor will abate in proportion to the number of beds remaining.
The Master Agreement provides that if during the Lease Term or within six months after termination of such Term NHR receives a bona fide third party offer to purchase any Healthcare Facility, then, prior to accepting such third party offer, NHR shall give NHC a 15-day right of first refusal during which NHC may elect to purchase such Healthcare Facility on the same terms and conditions offered by the third party. NHC also is granted a thirty day right of first refusal to lease an Healthcare Facility expiring six months after the expiration of the Lease Term, on the same terms and conditions as offered by a third party, and accepted by NHR.
Various other provisions of the Master Agreement with respect to Leases of the various Healthcare Facilities provide for arbitration in the event of NHR and NHC's inability to resolve disputes under the Master Agreement or any Lease. Such Agreement also provides that upon its termination and the last of the Leases between NHR and NHC, NHR will, upon NHC's request within 12 months after such termination, use its best efforts to change its corporate name to a name that does not include the word "National".
The Master Agreement described above applies only to the 24 Leases of the Healthcare Facilities. NHR and NHC anticipate that any future leases of additional healthcare facilities between them will also become subject to the Master Agreement with appropriate modifications to fit the specific situation. The foregoing summary of certain of the provisions of the Master Agreement does not purport to be complete and is subject to and qualified in its entirety by reference to all provisions of the Master Agreement.
Advisory, Administrative Services and Facilities Agreement (the Advisory Agreement)
Services of Advisor
Under the Advisory Agreement, NHR engages NHC and NHC , as Advisor, agrees to use its best efforts (a) to present to NHR a continuing and suitable investment program consistent with NHR's investment policy; (b) to manage the day-to-day affairs and operations of NHR; and (c) to provide administrative services and facilities appropriate for such management. In performing its obligations under the Agreement, the Advisor is subject to the supervision of and policies established by NHR's Board of Directors.
The specific duties of the Advisor under the Advisory Agreement include providing NHR with economic information and evaluations with respect to additional investment opportunities, formulating an investment program and selecting potential investments for NHR and recommending the terms thereof; and also evaluating and making recommendations as to the possible sale or other disposition of the assets of NHR. The Advisor also is responsible for recommending selections of tenants, lenders, providers of professional and specialized services and handling other managerial functions with respect to NHR's properties. The Advisor is also obligated to provide office and clerical facilities adequate for NHR's operations, and to provide or obtain others to provide accounting, custodial, funds collection and payment, stockholder and debenture holder communications, legal and other services necessary in connection with NHR's operations. The Advisor also undertakes to keep NHR's Directors informed as to developments in the healthcare and REIT industries useful to NHR's existing and potential future business and investments.
The NHR Advisory Agreement also obligates the Advisor to handle or arrange for the handling of NHR's financial and other records. The Advisor is also required to keep its own records with respect to its services under the NHR Advisory Agreement. Annually, or as more frequently requested by NHR's Directors, the Advisor is obligated to report to NHR Directors its estimated costs in providing services under the NHR Advisory Agreement and such information as the Advisor may reasonably obtain concerning the cost to other REITs specializing in healthcare facility investments of administrative and advisory services comparable to those provided by the Advisor, in order that NHR's Directors may evaluate the performance of the Advisor and the efficiency of the arrangements provided to NHR under the Advisory Agreement.
Restrictions on Investment Activities
The Advisory Agreement provides that prior to the earlier to occur of (I) the termination, for any reason, of the Advisory Agreement or (ii) NHC ceasing to be actively engaged as the investment advisor for NHI, NHR will not (without the prior approval of NHI) transact business with any party, person, company or firm other than NHC. It is the intent of the foregoing restriction that NHR will not be actively or passively engaged in the pursuit of additional investment opportunities, but rather will focus upon its capacities as landlord and note holder of those certain assets, conveyed to it on December 31, 1997, by NHC.
Term
The Advisory Agreement is for a stated term expiring December 31, 2003 and thereafter from year to year unless earlier terminated. However, either party may terminate the Advisory Agreement at any time on or after January 1, 2000 on 90 days written notice, and NHR may terminate the Advisory Agreement for cause at any time.
Upon termination of the Advisory Agreement for any reason, the Advisor is obligated to deliver all property of NHR that the Advisor is holding in its capacity as Advisor, to render a full accounting to NHR and to cooperate with NHR Directors to provide an orderly management transition. NHR is obligated, upon such termination, to pay NHC all compensation for services through the date of termination, including any compensation the payment of which was deferred during the period the Advisory Agreement was in effect.
Compensation
For its services under the Advisory Agreement, NHC is entitled to annual compensation of the greater of (I) two percent (2%) of NHR's gross consolidated revenues calculated according to generally accepted accounting principles, or (ii) the actual expenses incurred by NHC as outlined in the Advisory Agreement. The actual amount paid in 1998 was $471,000.
Payment of Expenses
The Advisory Agreement provides that NHC shall pay all expenses incurred in performing its obligations thereunder, without regard to the amount of compensation received under the Advisory Agreement. Expenses specifically listed as expenses to be borne by NHC without reimbursement include: the cost of accounting, statistical or bookkeeping equipment necessary for the maintenance of NHR's books and records; employment expenses of the officers and directors and personnel of NHC and all expenses, including travel expenses, of NHC incidental to the investigation and acquisition of properties for NHR prior to the time NHR Directors definitively decide to acquire the property or to have NHC continue with the acquisition process, whether the property is acquired or not, and after NHR Directors definitively decide to dispose of a property; advertising and promotional expenses incurred in seeking and disposing of investments for NHR; rent, telephone, utilities, office furniture and furnishings and other office expenses incurred by or allocable to NHC for its own benefit and account regardless of whether incurred or used in connection with rendering the services to NHR provided for in the NHR Advisory Agreement; all miscellaneous administrative and other expenses of NHC, whether or not relating to the performance by NHC of its functions under the NHR Advisory Agreement; fees and expenses paid to independent contractors, appraisers, consultants, attorneys, managers and other agents retained by or on behalf of NHR and expenses directly connected with the acquisition, financing, refinancing, disposition and ownership of real estate interests or of other property (including insurance premiums, legal services, brokerage and sales commissions, maintenance, repair and improvement of property); insurance as required by NHR Directors (including NHR Directors' liability insurance); expenses connected with payments of dividends or distributions in cash or any other form made or caused to be made by NHR Directors to REIT shareholders and expenses connected with payments of interest to holders of NHR's debentures; all expenses connected with communication to holders of securities of NHR and the other bookkeeping and clerical work necessary in maintaining relations with holders of securities, including the cost of printing and mailing certificates for securities and proxy solicitation materials and reports to holders of NHR's securities; transfer agent's, registrar's, dividend disbursing agent's, dividend reinvestment plan agent's and indenture trustee's fees and charges. The NHR Advisory Agreement also confirms that NHC shall pay all costs and expenses which it is obligated to pay as tenant under any lease of healthcare facilities from NHR.
The NHR Advisory Agreement also confirms that NHC is responsible for all legal and auditing fees and expenses of NHR and legal, auditing accounting, underwriting, brokerage, listing, registration and other fees and printing, engraving and other expenses and taxes incurred in connection with the organization of NHR, but such expenses incurred after January 1, 1998 for the issuance, distribution, transfer, registration and listing of NHR Shares shall remain NHR's obligation.
The NHR Advisory Agreement provides that, except as NHC may have responsibility for such costs as tenant under the lease of any property from NHR, NHR is responsible to pay its own expenses of the following types: dividends, the cost of borrowed money; taxes on income and taxes and assessments on real property and all other taxes applicable to NHR including, without limitation, franchise and excise fees; except as assumed by NHC, all ordinary and necessary expenses incurred with respect to and allocable to the prudent operation and business of NHR including, without limitation, any fees, salaries and other employment costs, taxes and expenses paid to NHR Directors, officers and employees of NHR who are not also employees of NHC.
PART IV ---------- ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
a) (1) Financial Statements:
The Financial Statements are included in Item 8 and are filed as part of this report.
(2) Financial Statement Schedules
The Financial Statement Schedules and Report of Independent Public Accountants on Financial Statement Schedules are listed in Exhibit 13.
(3) Exhibits:
Reference is made to the Exhibit Index of this Form 10-K Annual Report.
b) Reports on Form 8-K: None.
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 Murfreesboro, State of Tennessee, on the 11th day of March, 1999.
NATIONAL HEALTH REALTY, INC.
BY:/S/ Richard F. LaRoche, Jr. Richard F. LaRoche, Jr. Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed on the dates indicated by the following persons in the capacities indicated.
Signature Title Date
/s/ W. Andrew Adams President & Director March 11, 1999 W. Andrew Adams Principal Executive Officer
/s/ Richard F. LaRoche, Jr. Secretary and Director March 11, 1999 Richard F. LaRoche, Jr. Principal Financial Officer
/s/ J. K. Twilla Director March 11, 1999 J. K. Twilla
/s/ Robert G. Adams Director March 11, 1999 Robert G. Adams
/s/ Olin O. Williams Director March 11, 1999 Olin O. Williams
/s/ Ernest G. Burgess, III Director March 11, 1999 Ernest G. Burgess, III
EXHIBIT INDEX
Exhibit No. Description
2.1 Plan of Restructure (incorporated by reference to Exhibit 2.1 to the Registrant's registration statement No. 333-37173 on Form S-4).
2.2 Agreement of Merger (incorporated by reference to Exhibit 2.2 to the Registrant's registration statement No. 333-37173 on Form S-4).
3.1 Articles of Incorporation of National Health Realty, Inc. (incorporated by reference to Exhibit 3.1 to the Registrant's registration statement No. 333-37173 on Form S-4).
3.2 Bylaws of National Health Realty, Inc. (incorporated by reference to Exhibit 3.2 to the Registrant's registration statement No. 333-37173 on Form S-4).
3.3 Limited Partnership Agreement of NHR/OP, L.P.(incorporated by reference to Exhibit 3.3 to the Registrant's registration statement No. 333-37173 on Form S-4).
4 Indenture of Trust and Security Agreement dated as of December 1, 1990 by and among National Health Corporation Leveraged Employee Stock Ownership Trust, National Health Corporation, and National HealthCorp L.P. to State Street Bank and Trust Company of Connecticut, National Association, as Indenture Trustee and Barnett Banks Trust Company, National Association, as Florida Co-Indenture Trustee (incorporated by reference to Exhibit 4 to the Registrant's registration statement No. 333-37173 on Form S-4).
10.1 Master Agreement of Lease effective as of January 1, 1998 by and among National Health Realty, Inc., NHR/OP, L.P. and National HealthCare Corporation (incorporated by reference to Exhibit 10.1 to the Registrant's registration statement No. 333-37173 on Form S-4).
10.2 Advisory, Administrative Services and Facilities Agreement effective as of January 1, 1998 between National Health Realty, Inc., NHR/OP, L.P. and National HealthCare Corporation (incorporated by reference to Exhibit 10.2 to the Registrant's registration statement No. 333-37173 on Form S-4)
10.3.2 Form of National Health Realty, Inc. 1997 Stock Option and Stock Appreciation Rights Plan (incorporated by reference to Exhibit 10.3.2 to the Registrant's registration statement No. 333-37173 on Form S-4)
10.4 Loan Agreement dated as of April 21, 1995 by and between National HealthCare L.P. and First American National Bank (incorporated by reference to Exhibit 10.4 to the Registrant's registration statement No. 333-37173 on Form S-4)
10.5 Credit Agreement dated as of December 31, 1996 by and among National HealthCare L.P., The Banks, and SunTrust Bank, Nashville, N.A., as Agent (incorporated by reference to Exhibit 10.5 to the Registrant's registration statement No. 333-37173 on Form S-4)
10.6 Reimbursement and Letter of Credit Agreement dated as of June 1, 1989 among West Plains Manor, National HealthCare L.P. and The Bank of Tokyo, Ltd. New York Agency (incorporated by reference to Exhibit 10.6 to the Registrant's registration statement No. 333-37173 on Form S-4)
10.7 Guaranty Agreement dated as of June 1, 1989 by and between National HealthCare L.P. and The Bank of Tokyo, Ltd., New York Agency Subsidiaries of the Registrant (incorporated by reference to Exhibit 10.7 to the Registrant's registration statement No. 333-37173 on Form S-4)
13 Financial Statement Schedules
21 Subsidiaries of the Registrant
23 Consent of Independent Public Accountants
27 Financial Data Schedule (for SEC purposes only)
EXHIBIT 13 NATIONAL HEALTH REALTY, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES
Financial Statement Schedules
Report of Independent Public Accountants on Financial Statement Schedules
Schedule III Real Estate and Accumulated Depreciation
Schedule IV Mortgage Loans on Real Estate
All other schedules are not submitted because they are not applicable or not required or because the required information is included in the financial statements or notes thereto.
The 1998 consolidated balance sheet and consolidated statement of cash flows, together with the Report of Independent Public Accounts, listed in the above index are filed herewith.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES
To National Health Realty, Inc.:
We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of National Health Realty, Inc. included in Item 8 of this Form 10-K, and have issued our report thereon dated January 13, 1999. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The financial statement schedules listed in the accompanying index to Exhibit 13 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not otherwise a required part of the basic consolidated financial statements. The financial statement schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Nashville, Tennessee January 13, 1999
EXHIBIT 21 NATIONAL HEALTH REALTY, INC. SUBSIDIARY OF NATIONAL HEALTH REALTY, INC.
Subsidiary State of Organization
NHR/OP, L.P. Delaware
NHR/Delaware, Inc. Delaware
EXHIBIT 23
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our reports included in this Form 10-K into the Company's previously filed Registration Statement File No. 333-61699.
ARTHUR ANDERSEN LLP
Nashville, Tennessee March 11, 1999