HEALTH CARE REIT INC /DE/ - 10-K Annual Report

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2003
COMMISSION FILE NO. 1-8923

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HEALTH CARE REIT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 34-1096634
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)

ONE SEAGATE, SUITE 1500, TOLEDO, OHIO 43604
(Address of principal executive office) (Zip Code)

(419) 247-2800
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months; and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]

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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]

The aggregate market value of the shares of voting common stock held by
non-affiliates of the Registrant, computed by reference to the closing sales
price of such shares on the New York Stock Exchange as of the last business day
of the Registrant's most recently completed second fiscal quarter was
$1,241,737,000.

As of March 11, 2004, there were 51,098,962 shares of common stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's definitive proxy statement for the annual
stockholders' meeting to be held May 6, 2004, are incorporated by reference into
Part III.
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HEALTH CARE REIT, INC.
2003 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

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PART I

ITEM 1. BUSINESS

GENERAL

Health Care REIT, Inc., a Delaware corporation, is a self-administered,
equity real estate investment trust that invests in health care facilities,
primarily skilled nursing and assisted living facilities. We also invest in
specialty care facilities. As of December 31, 2003, long-term care facilities,
which include skilled nursing and assisted living facilities, comprised
approximately 92% of our investment portfolio. Founded in 1970, we were the
first real estate investment trust to invest exclusively in health care
facilities.

As of December 31, 2003, we had $2,003,466,000 of net real estate
investments, inclusive of credit enhancements, in 328 facilities located in 33
states and managed by 47 different operators. At that date, the portfolio
included 219 assisted living facilities, 101 skilled nursing facilities and
eight specialty care facilities.

Our primary objectives are to protect stockholders' capital and enhance
stockholder value. We seek to pay consistent cash dividends to stockholders and
create opportunities to increase dividend payments from annual increases in
rental and interest income and portfolio growth. To meet these objectives, we
invest primarily in long-term care facilities managed by experienced operators
and diversify our investment portfolio by operator and geographic location.

We anticipate investing in additional health care facilities through
operating lease arrangements with, and loans for, qualified health care
operators. Capital for future investments may be provided by borrowing under our
lines of credit, public offerings or private placements of debt or equity or the
incurrence of secured indebtedness.

References herein to "we," "us," "our" or the "Company" refer to Health
Care REIT, Inc. and its subsidiaries unless specifically noted otherwise.

PORTFOLIO OF PROPERTIES

The following table summarizes our portfolio as of December 31, 2003:

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(1) Investments include real estate investments and credit enhancements which
amounted to $2,000,271,000 and $3,195,000, respectively.

(2) Investment per Bed/Unit was computed by using the total investment amount of
$2,018,967,000 which includes real estate investments, credit enhancements
and unfunded construction commitments for which initial funding has
commenced which amounted to $2,000,271,000, $3,195,000 and $15,501,000,
respectively.

(3) We have investments in properties located in 33 states and managed by 47
different operators.

ASSISTED LIVING FACILITIES

An assisted living facility is a special combination of housing,
personalized supportive services and health care services designed to meet the
needs -- both scheduled and unscheduled -- of those who need help with
activities of daily living. Certain of our assisted living facilities include
other care levels, including independent living, dementia care, and nursing
services. More intensive medical needs of the resident within assisted living

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facilities may be provided by home health providers. Assisted living facilities
represent less costly and less institutional-like alternatives for the care of
the elderly or the frail.

SKILLED NURSING FACILITIES

Skilled nursing facilities provide inpatient skilled nursing and personal
care services as well as rehabilitative, restorative and transitional medical
services. In some instances, skilled nursing facilities supplement hospital care
by providing specialized care for medically complex patients whose conditions
require intense medical and therapeutic services, but who are medically stable
enough to have these services provided in facilities that are less expensive
than acute care hospitals.

SPECIALTY CARE FACILITIES

Our specialty care facilities include acute care hospitals, long-term acute
care hospitals and other specialty care hospitals. Acute care hospitals provide
a wide range of inpatient and outpatient services including, but not limited to,
surgery, rehabilitation, therapy and clinical laboratories. Long-term acute care
hospitals provide inpatient services for patients with complex medical
conditions that require more intensive care, monitoring or emergency support
than that available in most skilled nursing facilities. Other specialty care
hospitals provide specialized inpatient and outpatient services for specific
illnesses or diseases including, among others, orthopedic, neurosurgical and
behavioral care.

INVESTMENTS

We invest in health care facilities with a primary focus on long-term care
facilities, which include skilled nursing and assisted living facilities. We
also invest in specialty care facilities. We diversify our investment portfolio
by operator and geographic location.

In determining whether to invest in a facility, we focus on the following:
(a) the experience of the tenant's or borrower's management team; (b) the
historical and projected financial and operational performance of the facility;
(c) the credit of the tenant or borrower; (d) the security for the lease or
loan; and (e) the capital committed to the facility by the tenant or borrower.
We conduct market research and analysis for all potential investments. In
addition, we review the value of all facilities, the interest rates and debt
service coverage requirements of any debt to be assumed and the anticipated
sources for repayment of any debt.

Our investments are primarily real property leased to operators under
operating leases and mortgage loans. Construction financing is provided, but
only as part of a long-term operating lease or mortgage loan. We typically
invest in or finance up to 90% of the stabilized appraised value of a property.
Economic terms normally include annual rate increases and fair market value
based purchase options in operating leases. Depending upon market conditions, we
believe that appropriate new investments will be available in the future with
spreads over our cost of capital that will generate appropriate returns to our
stockholders. Operating leases and mortgage loans are normally credit enhanced
by guaranties and/or letters of credit. In addition, operating leases are
typically structured as master leases and mortgage loans are generally
cross-defaulted and cross-collateralized with other mortgage loans, operating
leases or agreements between us and the operator and its affiliates.

At December 31, 2003, 80% of our owned real property was subject to master
leases. A master lease is a lease of multiple facilities from us to one tenant
entity under a single lease agreement. From time to time, we may acquire
additional facilities that are then leased to the tenant under the master lease.
The tenant is required to make one monthly payment that represents rent on all
the properties that are subject to the master lease. Typically, the master lease
tenant can exercise its right to purchase the facilities or to renew the master
lease only with respect to all leased facilities at the same time. This
"bundling" feature benefits us because the tenant cannot limit the purchase or
renewal to the better performing facilities and terminate the leasing
arrangement with respect to the poorer performing facilities. This spreads our
risk among the entire group of facilities within the master lease. The bundling
feature may provide a similar advantage if the master lease tenant is in
bankruptcy. Subject to certain restrictions, a debtor in bankruptcy has the
right to assume or reject

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each of its leases. It is our intent that a tenant who is in bankruptcy would be
required to assume or reject the master lease as a whole, rather than making the
decision on a facility by facility basis.

We monitor our investments through a variety of methods determined by the
type of health care facility and operator. Our monitoring process includes
review of monthly financial statements for each facility, quarterly review of
operator credit, annual facility inspections and review of covenant compliance
relating to licensure, real estate taxes, letters of credit and other
collateral. In monitoring our portfolio, our personnel use a proprietary
database to collect and analyze facility-specific data. Additionally, we conduct
extensive research to ascertain industry trends and risks.

Through monitoring and research, we evaluate the operating environment in
each facility's market to determine whether payment risk is likely to increase.
When we identify unacceptable levels of payment risk, we seek to mitigate,
eliminate or transfer the risk. We typically categorize the risk as operator,
facility or market risk. For operator risk, we typically find a substitute
operator to run the facility. For facility risk, we usually work with the
operator to institute facility level management changes to address the risk.
Finally, for market risk, we often encourage an operator to change its capital
structure, including refinancing or raising additional equity. Through these
monitoring and research efforts, we are typically able to intervene at an early
stage and address payment risk, and in so doing, support both the collectibility
of revenue and the value of our investment.

OPERATING LEASES

Each facility, which includes the land, buildings, improvements and related
rights, owned by us is leased to an operator pursuant to a long-term operating
lease. As discussed above, most of our leased properties are subject to master
leases. The leases generally have a fixed term of seven to 15 years and contain
one or more five to 15-year renewal options. Each lease is a net lease requiring
the tenant to pay rent and all additional charges incurred in the operation of
the leased property. The tenants are required to repair, rebuild and maintain
the leased properties.

The net value of our completed leased properties aggregated approximately
$1,726,836,000 at December 31, 2003. Operating lease income generally includes
base rent payments plus fixed annual rent increases, which are generally
recognized on a straight-line basis over the minimum lease period. This lease
income is greater than the amount of cash received during the first half of the
lease term. In some instances (representing approximately 21% of real property),
the leases provide for additional payment of rent if the gross operating
revenues from the property exceed a predetermined threshold. Revenues are not
recognized until these thresholds have been met. Rents, as recognized using the
straight-line method where applicable, on the original lease basis of our
completed leased properties are approximately 11.5% per annum on average at
December 31, 2003. Our rental yield from leases depends upon a number of
factors, including the initial rent charged, up-front fees, any rental
adjustments and, in some cases, facility-level revenue. The base rents for the
renewal periods are generally fixed rents set at the greater of a minimum agreed
upon rate of return or a spread above the Treasury yield for the corresponding
period, generally with a floor of the prior year's rate of return plus the
annual increaser.

We currently provide for the construction of facilities for the tenants as
part of long-term operating leases. We capitalize certain interest costs
associated with funds used to finance the construction of properties owned
directly by us. The amount capitalized is based upon the balance outstanding
during the construction period using the rate of interest that approximates our
cost of financing. Our interest expense is reduced by the amount capitalized. We
also typically charge a transaction fee at the commencement of construction. The
construction period commences upon funding and terminates upon the earlier of
the completion of the applicable facility or the end of a specified period,
generally 12 to 18 months. During the construction period, we advance funds to
the operator in accordance with agreed upon terms and conditions which require,
among other things, a site visit by a Company representative prior to the
advancement of funds. During the construction period, we generally require
additional credit enhancement in the form of payment and performance bonds
and/or completion guaranties. At December 31, 2003, we had outstanding
construction

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financings of $14,865,000 ($14,701,000 for leased properties and $164,000 for
construction loans) and were committed to providing additional financing of
approximately $15,501,000 to complete construction.

MORTGAGE LOANS

Our investments in mortgage loans are typically structured to provide us
with interest income, principal amortization and transaction fees and are
generally secured by a first or second mortgage lien or leasehold mortgage.

At December 31, 2003, the interest rates averaged approximately 11.1% per
annum on our outstanding mortgage loan balances. Our yield on mortgage loans
depends upon a number of factors, including the stated interest rate, average
principal amount outstanding during the term of the loan and any interest rate
adjustments.

The mortgage loans made through December 31, 2003, are generally subject to
three to 20-year terms with principal amortization schedules and/or balloon
payment of the outstanding principal balance at the end of the term. Generally,
the mortgage loans provide three to eight years of prepayment protection.

WORKING CAPITAL LOANS

Working capital loans are short-term loans made to operators of facilities
and are typically either secured and/or guaranteed. These instruments have terms
ranging from three months to ten years. At December 31, 2003, the average
interest rates (excluding any loans on non-accrual) were approximately 10.7% per
annum on our outstanding working capital loan balances. At December 31, 2003, we
had provided working capital loans to nine operators.

SUBDEBT INVESTMENTS

Subdebt investments are loans made to operators of facilities and are
generally secured by the operator's leasehold rights and corporate guaranties.
Generally, these instruments are for four to seven-year terms. At December 31,
2003, the average interest rates were approximately 12.0% per annum on our
outstanding subdebt investment balances. At December 31, 2003, we had provided
subdebt financing to five operators.

EQUITY INVESTMENTS

We had an investment in Atlantic Healthcare Finance L.P., a property group
that specializes in the financing, through sale and leaseback transactions, of
nursing and care homes located in the United Kingdom. This investment was
accounted for under the equity method of accounting because we had the ability
to exercise significant influence, but not control, over the company due to our
31% ownership interest. In October 2003, we sold our investment in Atlantic
Healthcare Finance L.P. generating a net gain of $902,000.

Other equity investments, which consist of investments in private and
public companies for which we do not have the ability to exercise influence, are
accounted for under the cost method. Under the cost method of accounting,
investments in private companies are carried at cost and are adjusted only for
other-than-temporary declines in fair value, distributions of earnings and
additional investments. For investments in public companies that have readily
determinable fair market values, we classify our equity investments as
available-for-sale and, accordingly, record these investments at their fair
market values with unrealized gains and losses included in accumulated other
comprehensive income, a separate component of stockholders' equity. These
investments represent a minimal ownership interest in these companies.

BORROWING POLICIES

We may incur long-term indebtedness through public offerings or private
placements. For short-term purposes, we may, from time to time, obtain lines of
credit or other short-term borrowings from banks or others. When terms are
deemed favorable, we may invest in properties subject to existing mortgage
indebtedness. In addition, we may obtain financing for unleveraged properties in
which we have invested or

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may refinance properties acquired on a leveraged basis. Under documents
pertaining to existing indebtedness, we are subject to various restrictions with
respect to secured and unsecured indebtedness.

MAJOR OPERATORS

The following table summarizes certain information about our operator
concentrations as of December 31, 2003 (dollars in thousands):

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(1) Investments include real estate investments and credit enhancements which
amounted to $2,000,271,000 and $3,195,000, respectively.

(2) Investments with our top five operators comprised 45% of total investments
at December 31, 2002.

(3) Revenues include gross revenues and revenues from discontinued operations
for the year ended December 31, 2003.

(4) Revenues from our top five operators were 43% and 40% for the years ended
December 31, 2002 and 2001, respectively.

COMPETITION

We compete with other real estate investment trusts, real estate
partnerships, banks, insurance companies, finance companies, government
sponsored agencies, tax and tax-exempt bond funds and other investors in the
acquisition, leasing and financing of health care facilities. We compete for
investments based on a number of factors including rates, financings offered,
underwriting criterion and reputation. The operators of our facilities compete
on a local and regional basis with operators of facilities that provide
comparable services. Operators compete for patients and residents based on a
number of factors including quality of care, reputation, physical appearance of
facilities, services offered, family preferences, physicians, staff and price.

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EMPLOYEES

As of December 31, 2003, we employed 34 full-time employees.

CERTAIN GOVERNMENT REGULATIONS

HEALTH LAW MATTERS -- GENERALLY

We invest in assisted living, skilled nursing and specialty care
facilities, which represent approximately 60%, 32% and 8%, respectively, of our
investments at December 31, 2003.

Typically, operators of assisted living facilities do not receive
significant funding from governmental programs and are regulated by the states,
not the federal government. Operators of skilled nursing and specialty care
facilities are subject to federal and state laws that regulate the type and
quality of the medical and/or nursing care provided, ancillary services (e.g.,
respiratory, occupational, physical and infusion therapies), qualifications of
the administrative personnel and nursing staff, the adequacy of the physical
plant and equipment, distribution of pharmaceuticals, reimbursement and rate
setting and operating policies. In addition, as described below, some of our
facility operators are subject to extensive laws and regulations pertaining to
health care fraud and abuse, including kickbacks, physician self-referrals and
false claims.

LICENSING AND CERTIFICATION

The primary regulations that affect assisted living facilities are the
states' licensing laws. In granting and renewing these licenses, the regulatory
authorities consider numerous factors relating to a facility's physical plant
and operations including, but not limited to, admission and discharge standards
and staffing and training. A decision to grant or renew a license is also
affected by a facility's record with respect to consumer rights and medication
guidelines and rules.

Generally, our skilled nursing and specialty care facilities are required
to be licensed on an annual or bi-annual basis and to be certified for
participation in the Medicare and Medicaid programs. These facilities are
subject to audits and surveys by various regulatory agencies that determine
compliance with federal, state and local laws. The failure of our facility
operators to maintain or renew any required license or regulatory approval or
serious survey deficiencies could prevent them from continuing operations at a
property. In addition, if a facility is found out of compliance with the
conditions of participation in Medicare, Medicaid or other health care programs,
or if a facility is otherwise excluded from those programs, the facility may be
barred from participation in government reimbursement programs. Any of these
occurrences may impair the ability of our operators to meet their obligations to
us. If we have to replace a facility operator, our ability to replace the
operator may be affected by federal and state rules and policies governing
changes in control. Under current Medicare and Medicaid rules and regulations
and provider contracts, a successor operator that assumes an existing provider
agreement will typically be subject to certain liabilities of the previous
operator, including overpayments, terms under any existing plan of correction
and possibly sanctions and penalties. If a successor operator chooses to apply
for a new Medicare and/or Medicaid provider agreement, the successor operator
may experience interruptions and delays in reimbursement during the processing
of its application for a new provider agreement or its application may not be
approved. This may result in payment delays, an inability to find a replacement
operator, a significant working capital commitment from us to a new operator or
other difficulties.

REIMBURSEMENT

Assisted Living Facilities. Approximately 57% of our revenues for the year
ended December 31, 2003, were attributable to assisted living facilities. The
majority of the revenues received by the operators of our assisted living
facilities are from private pay sources. The remaining revenue source is
primarily Medicaid waiver programs. Forty-one states currently have such
programs, which allow Medicaid recipients to use benefits for alternatives to
skilled nursing such as assisted living and home health. The National Academy
for State Health Policy reports that Medicaid waiver programs serve about
102,000 residents in assisted living or residential care settings. At December
31, 2003, 12 of our 31 assisted living operators utilized Medicaid

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waivers. For the year ended December 31, 2003, approximately 5% of the revenues
at our assisted living facilities were from Medicaid reimbursement.

Rates paid by self-pay residents are set by the facilities and are largely
determined by local market conditions and operating costs. Generally, facilities
receive a higher payment per day for a private pay resident than for a Medicaid
beneficiary who requires a comparable level of care. The level of Medicaid
reimbursement varies from state to state, but rarely includes reimbursement for
room and board. Thus, the revenues generated by operators of our assisted living
facilities may be adversely affected by payor mix, acuity level and changes in
Medicaid eligibility and reimbursement levels. Changes in revenues could in turn
have a material adverse effect on an operator's ability to meet its obligation
to us.

Skilled Nursing Facilities and Specialty Care Facilities. Skilled nursing
and specialty care facilities typically receive most of their revenues from
Medicare and Medicaid, with the balance representing private pay, including
private insurance. Consequently, skilled nursing and specialty care facilities
rely heavily on government reimbursement. Changes in federal or state
reimbursement policies, including changes in payment rates as a result of
federal or state regulatory action, or payment delays by fiscal intermediaries
may also adversely affect an operator's ability to cover its expenses, including
our rent or debt service. Skilled nursing and specialty care facilities are
subject to periodic pre- and post-payment reviews and other audits by federal
and state authorities. A review or audit of claims against a facility operator
could result in recoupments, denials or delays of payments in the future, which
could have a material adverse effect on the operator's ability to meet its
obligations to us. Due to the significant judgments and estimates inherent in
payor settlement accounting, no assurance can be given as to the adequacy of any
reserves maintained by our facility operators for potential adjustments to
reimbursements for payor settlements. Due to budgetary constraints, governmental
payors may limit or reduce payments to skilled nursing and specialty care
facilities. As a result of government reimbursement programs being subject to
such budgetary pressures and legislative and administrative actions, an
operator's ability to meet its obligations to us may be significantly impaired.

Medicare Reimbursement and Skilled Nursing Facilities. For the year ended
December 31, 2003, approximately 28% of the revenues at our skilled nursing
facilities (which comprised 37% of our revenues for the year ended December 31,
2003) were from Medicare reimbursement. In an effort to reduce federal spending
on health care, the Balanced Budget Act of 1997 ("BBA") contained extensive
changes to the Medicare and Medicaid programs intended to reduce the projected
payments under these programs. The BBA fundamentally altered Medicare payment
methodologies for skilled nursing facilities by mandating the institution of the
skilled nursing facility prospective payment system. This system differs
significantly from the prior cost-based reimbursement system. Among other
things, it sets per diem rates based on 1995 cost reports as adjusted by a
variety of factors, including, but not limited to, costs associated with 44
resource utilization group categories ("RUGs"). The payments received under the
skilled nursing facility prospective payment system cover services for Medicare
patients, including all ancillary services, such as respiratory, physical, and
occupational therapy and certain covered medications. The skilled nursing
facility prospective payment system caused Medicare per diem reimbursement for
skilled nursing facility services to decrease. The reductions in Medicare
payments resulted in immediate financial difficulties for skilled nursing
facilities and caused a number of operators to seek bankruptcy protection.

Since the BBA's passage in 1997, the federal government has passed
legislation to lessen the negative financial impact from the prospective payment
system. For example, under the Balanced Budget Refinement Act of 1999 ("BBRA")
and the Benefits Improvement and Patient Protection Act of 2000 ("BIPA"), some
of the mandatory reductions in Medicare payment increases were reversed or
delayed, and skilled nursing facilities received temporary payment increases.
BBRA included two key provisions: [i] a 20% increase for 15 of the RUGs and [ii]
a 4% across-the-board increase to the federal per diem rate. The 20% increase
was implemented in April 2000 and will remain in effect until the implementation
of refinements in the current RUG case-mix classification system. The 4%
increase was implemented in April 2000 and expired on September 30, 2002. BIPA
also included two key provisions: [i] a 16.66% increase in the nursing component
of the federal per diem rate and [ii] a 6.7% increase in the 14 RUG payments for
rehabilitation therapy services. The 16.66% increase was implemented in April of
2001 and expired on September 30, 2002. The 6.7% increase is an adjustment to
the 20% increase granted in BBRA and spreads the funds directed at three
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of those 15 RUGs to an additional 11 rehabilitation RUGs. This increase was
implemented in April 2001 and will remain in effect until the implementation of
refinements in the current RUG case-mix classification system. The 4% and 16.66%
increases that expired on September 30, 2002 decreased annual reimbursement by
roughly $1.8 billion. Although the Centers for Medicare and Medicaid Services
("CMS") did not implement RUG refinements for fiscal year 2004, annual
reimbursement will be reduced by roughly $1.0 billion if the new case-mix system
is implemented in the future. There is no assurance that the new case-mix
classification will account for this reduction so that nursing facilities are
not adversely affected.

Skilled nursing facilities received a 2.6% inflation basket increase in
Medicare payments for federal fiscal year 2003, which resulted in roughly $400
million in additional reimbursement. In addition, CMS did not refine the
existing RUG classification system for fiscal year 2003 or fiscal year 2004,
resulting in roughly $1.0 billion of additional annual reimbursement remaining
in place. For fiscal year 2004, Congress approved a 3.0% market basket increase
and CMS approved a 3.26% increase to the Medicare market basket update to
correct for historical errors in the inflation formula. The result of the two
separate inflationary updates is an addition of over $850 million to Medicare
reimbursement in fiscal year 2004. The Medicare Prescription Drug, Improvement,
and Modernization Act of 2003 imposed a moratorium on the therapy caps for Part
B outpatient rehabilitation services through December 31, 2005. The therapy caps
were mandated by the BBA. If ever imposed, the annual payment cap would apply
twice. A $1,590 cap per patient applies to occupational therapy and a second
$1,590 cap applies to physical and speech therapy combined. Patients exceeding
the cap would need to use private funds to pay for the cost of additional
therapy.

Medicare Reimbursement and Specialty Care Facilities. For the year ended
December 31, 2003, approximately 42% of the revenues at our specialty care
facilities (which comprised 6% of our revenues for the year ended December 31,
2003) were from Medicare. Our specialty care facilities generally are reimbursed
by Medicare under either the diagnosis related group/outpatient prospective
payment system reimbursement methodology for regular hospitals, or the new
prospective payment system for inpatient rehabilitation facilities. Our acute
care hospitals provide a wide range of inpatient and outpatient services
including, but not limited to, surgery, rehabilitation, therapy and clinical
laboratories. Our long-term acute care hospitals provide inpatient services for
patients with complex medical conditions that require more intensive care,
monitoring or emergency support than that available in most skilled nursing
facilities. Some of our other specialty care hospitals provide specialized
inpatient and outpatient services for specific illnesses or diseases including,
among others, orthopedic, neurosurgical and behavioral care services.

With respect to Medicare's diagnosis related group/outpatient prospective
payment system methodology for regular hospitals, reimbursement for inpatient
services is on the basis of a fixed, prospective rate based on the principal
diagnosis of the patient. Diagnoses are grouped into more than 500 diagnosis
related groups. In some cases, a hospital might be able to qualify for an
outlier payment if the hospital's charges exceed a threshold. CMS has revised
its outlier methodology in response to allegations that some hospitals increased
their outlier reimbursement by substantially increasing charges. Under the
revisions, outlier reimbursement for all hospitals is expected to decline. In
addition, the government is evaluating the past practices of hospitals relating
to outlier payments. If any of the operators of our specialty care facilities
were found to have substantially increased charges in an attempt to increase
outlier payments, there is a risk that such operators could be investigated and
required to refund a portion of outlier payments received plus possible
penalties.

Congress has limited increases in diagnosis related groups or outpatient
prospective payment system payments. These limited increases may not be
sufficient to cover specialty care facilities' increasing costs of providing
care. Failure to increase reimbursement to cover increased costs, or reductions
or freezes in payment rates, will have an adverse impact on operators of our
specialty care facilities.

The BBA, as amended by BBRA and BIPA, also authorized the development of a
prospective payment system for inpatient rehabilitation facilities, including
freestanding rehabilitation hospitals and rehabilitation units of acute care
hospitals. The inpatient rehabilitation facility prospective payment system
methodology replaces the reasonable cost-based payment system.

Under the final regulations that implemented the inpatient rehabilitation
facility prospective payment systems, rehabilitation hospitals are required to
complete a patient assessment instrument upon admission and
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discharge for all Medicare Part A fee-for-service patients who are already
inpatients or who are admitted or discharged on or after January 1, 2002. Based
on the data received from the inpatient rehabilitation facility patient
assessment instrument, each patient is placed into a case-mix group. Each
case-mix group is a functional-related group determined by distinguishing
classes of inpatient rehabilitation facility patient discharges on the basis of
impairment, age, co-morbidities, functional capability of the patient and other
factors the Medicare program deems appropriate to improve the explanatory power
of functional independence measure function related groups. The case mix group
determines the base payment rate for the Medicare-covered Part A services
furnished by the inpatient rehabilitation facility during the beneficiary's
episode of care. Inpatient rehabilitation facility prospective payment system
rates encompass the inpatient capital costs and operating costs, including
routine and ancillary costs, of furnishing covered rehabilitation services.
Other indirect operating costs (including, among other things, bad debts,
approved educational activities and non-physician anesthetist's services) are
not included. Payment rates are calculated using relative weights to account for
variations in resource needs in case mix groups.

Pursuant to the BBA, as amended by BBRA and BIPA, payments during fiscal
years 2001 and 2002 were budget neutral with payments for fiscal year 2001
equaling 98% of the amount of payments that would have been paid if the
inpatient rehabilitation facility prospective payment system had not been
enacted and 100% for fiscal year 2002. For cost reporting periods beginning on
or after October 1, 2002, payment is based solely on the adjusted federal
prospective payment.

The ability of our operators to adjust to the shift from reasonable cost
reimbursement to an inpatient rehabilitation facility prospective payment system
will impact the cash flow of these facilities. Failure to control costs or
manage the care provided under the inpatient rehabilitation facility prospective
payment system would have an adverse impact on our operators' ability to meet
their obligations to us.

Medicaid Reimbursement. Medicaid is a major payor source for residents in
our skilled nursing and specialty care facilities. For the year ended December
31, 2003, approximately 54% of the revenues of our skilled nursing facilities
and 38% of the revenues of our specialty care facilities were attributable to
Medicaid payments. The federal government and the states share responsibility
for financing Medicaid. The federal matching rate, known as the Federal Medical
Assistance Percentage ("FMAP"), varies between 50% and 77% by state based on
relative per capita income. Medicaid is typically the second largest item in
state budgets after elementary and secondary education. On average, the
Congressional Budget Office reports that Medicaid long-term care expenditures
represent about three-eighths of total Medicaid expenditures. However, the
percentage of Medicaid dollars used for long-term care varies dramatically from
state to state due to different ratios of elderly population and eligibility
requirements. States have a wide range of discretion to determine specific
reimbursement methodologies. Currently, some state Medicaid programs use a
cost-based reimbursement system in which the rate that a facility receives may
be based on the costs it historically incurred in providing patient care.
Reasonable costs typically include allowances for administrative and general
costs and costs of property and equipment (e.g., depreciation and fair rental).
Many Medicaid programs compute a per diem rate of reimbursement that is applied
prospectively. Certain states provide for efficiency incentives, subject to cost
ceilings. Many of these programs are subject to retrospective adjustment under
which a facility operator might be required to refund payments that exceed
incurred costs.

In most states, Medicaid does not fully reimburse the cost of providing
skilled nursing services. The shortfall is due in part to the BBA, which
repealed the Boren Amendment. The Boren Amendment required states to fund
Medicaid expenditures in an amount that was sufficient to cover the reasonable
costs of an efficient provider. Consequently, Medicaid funding is vulnerable to
state balanced budget requirements. Due to declining tax revenues, some states
are attempting to slow the rate of growth in Medicaid expenditures by freezing
rates or restricting eligibility and benefits. States will benefit from a
temporary increase in the FMAP from July 1, 2003 through September 30, 2004. The
Jobs and Growth Tax Relief Reconciliation Act of 2003 included a $10 billion
increase in the FMAP for Medicaid. States in which we have skilled nursing
facility investments increased their per diem Medicaid rates 4% on average for
fiscal year 2004. Despite the temporary federal funding relief and the budgeted
rate increases, rates for specific services and eligibility may decline if
revenues are not sufficient to fund budgeted expenditures.

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The reimbursement methodologies applied to health care facilities continue
to evolve. Federal and state authorities have considered and may seek to
implement new or modified reimbursement methodologies that may negatively impact
health care facility operations. The impact of any such change, if implemented,
may result in a material adverse effect on our skilled nursing and specialty
care facility operations. No assurance can be given that current revenue sources
or levels will be maintained. Accordingly, there can be no assurance that
payments under a government reimbursement program are currently or will, in the
future, be sufficient to fully reimburse the facility operators for their
operating and capital expenses. As a result, the operators' ability to meet
their obligations to us could be adversely impacted.

OTHER RELATED LAWS

Skilled nursing and specialty care facilities (and assisted living
facilities that receive Medicaid payments) are subject to federal, state and
local laws and regulations (including those laws and regulations prohibiting
fraud and abuse), which govern the operations and financial and other
arrangements that may be entered into by health care providers. Certain of these
laws prohibit direct or indirect payments of any kind for the purpose of
inducing or encouraging the referral of patients for medical products or
services reimbursable by governmental programs. Other laws require providers to
furnish only medically necessary services and submit to the government valid and
accurate statements for each service. Still other laws require providers to
comply with a variety of safety, health and other requirements relating to the
condition of the licensed facility and the quality of care provided. Sanctions
for violation of these laws and regulations may include, but are not limited to,
criminal and/or civil penalties and fines and a loss of licensure and immediate
termination of governmental payments. In certain circumstances, violation of
these rules (such as those prohibiting abusive and fraudulent behavior) with
respect to one facility may subject other facilities under common control or
ownership to sanctions, including disqualification from participation in the
Medicare and Medicaid programs. In the ordinary course of its business, a
facility operator is regularly subjected to inquiries, investigations and audits
by federal and state agencies that oversee these laws and regulations.

Each skilled nursing and specialty care facility (and any assisted living
facility that receives Medicaid payments) is subject to the federal
anti-kickback statute which generally prohibits persons from offering,
providing, soliciting or receiving remuneration to induce either the referral of
an individual or the furnishing of a good or service, for which payment may be
made under a federal health care program such as the Medicare and Medicaid
programs. Skilled nursing and specialty care facilities are also subject to the
federal Ethics in Patient Referral Act of 1989, commonly referred to as the
Stark Law. The Stark Law generally prohibits the submission of claims to
Medicare for payment if the claim results from a physician referral for certain
designated services and the physician has a financial relationship with the
health service provider that does not qualify under one of the exceptions for a
financial relationship under the Stark Law. Similar prohibitions on physician
self-referrals and submission of claims apply to state Medicaid programs.
Further, skilled nursing and specialty care facilities (and assisted living
facilities that receive Medicaid payments) are subject to substantial financial
penalties under the Civil Monetary Penalties Act and the False Claims Act and,
in particular, actions under the False Claims Act's "whistleblower" provisions.
Private enforcement of health care fraud has increased due in large part to
amendments to the False Claims Act that encourage private individuals to sue on
behalf of the government. These whistleblower suits by private individuals,
known as qui tam actions, may be filed by almost anyone, including present and
former patients and nurses and other employees. Prosecutions, investigations or
qui tam actions could have a material adverse effect on a facility operator's
liquidity, financial condition and results of operations which could adversely
affect the ability of the operator to meet its obligations to us. Finally,
various state false claim and anti-kickback laws also may apply to each facility
operator. Violation of any of the foregoing statutes can result in criminal
and/or civil penalties that could have a material adverse effect on the ability
of an operator to meet its obligations to us.

The Health Insurance Portability and Accountability Act of 1996, which
became effective January 1, 1997, greatly expanded the definition of health care
fraud and related offenses and broadened its scope to include private health
care plans in addition to government payors. It also greatly increased funding
for the Department of Justice, Federal Bureau of Investigation and the Office of
the Inspector General of the Department of Health and Human Services to audit,
investigate and prosecute suspected health care fraud.

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Additionally, the administrative simplification provisions of this law provide
for communication of health information through standard electronic transaction
formats and for the privacy and security of health information. In order to
comply with the regulations, health care providers must undergo significant
operational and technical changes, and these modifications may represent
significant costs for our health care providers. These additional costs may, in
turn, adversely affect the ability of our operators to meet their obligations to
us.

Finally, government investigation and enforcement of health care laws has
increased dramatically over the past several years and is expected to continue.
Some of these enforcement actions represent novel legal theories and expansions
in the application of false claims laws. For example, there have been a number
of complaints filed and settlements entered into by the United States Attorneys
Office in the Eastern District of Pennsylvania alleging that the failure to meet
certain conditions of participation renders claims for the care false on the
theory that inadequate care was provided. The costs for an operator of a health
care facility associated with both defending such enforcement actions and the
undertakings in settlement agreements can be substantial and could have a
material adverse effect on the ability of an operator to meet its obligations to
us.

TAXATION

FEDERAL INCOME TAX CONSIDERATIONS

The following summary of the taxation of the Company and the material
federal tax consequences to the holders of our stock is for general information
only and is not tax advice. The tax treatment of our stockholders will depend on
a stockholder's particular situation, and this summary only applies to you to
the extent that you hold our stock as a capital asset. This discussion does not
deal with special tax situations such as those relating to insurance companies,
financial institutions or broker-dealers.

This summary does not discuss all of the aspects of U.S. federal income
taxation that may be relevant to you in light of your particular investment or
other circumstances. In addition, this summary does not discuss any U.S. state
or local income or foreign income or other tax consequences. This summary is
based on current U.S. federal income tax law. Subsequent developments in U.S.
federal income tax law, including changes in law or differing interpretations,
which may be applied retroactively, could have a material effect on the U.S.
federal income tax consequences of purchasing, owning and disposing of our stock
as set forth in this summary. Before you purchase our stock, you should consult
your own tax advisor regarding the particular U.S. federal, state, local,
foreign and other tax consequences of acquiring, owning and selling our stock.

General

We elected to be taxed as a real estate investment trust (or REIT)
commencing with our first taxable year. We intend to continue to operate in such
a manner as to qualify as a REIT, but there is no guaranty that we will qualify
or remain qualified as a REIT for subsequent years. Qualification and taxation
as a REIT depends upon our ability to meet a variety of qualification tests
imposed under federal income tax law with respect to income, assets,
distribution level and diversity of share ownership and discussed below under
"-- Qualification as a REIT." There can be no assurance, however, that we will
be owned or organized in a manner so as to qualify or remain qualified as a
REIT.

In any year in which we qualify as a REIT, in general, we will not be
subject to federal income tax on that portion of our REIT taxable income or
capital gain that is distributed to stockholders. We may, however, be subject to
tax at normal corporate rates upon any taxable income or capital gain not
distributed. If we elect to retain and pay income tax on our net long-term
capital gain, stockholders are required to include their proportionate share of
our undistributed long-term capital gain in income, but they will receive a
refundable credit for their share of any taxes paid by us on such gain.

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Despite the REIT election, we may be subject to federal income and excise
tax as follows:

- to the extent that we do not distribute all of our net capital gain or
distribute at least 90%, but less than 100%, of our "REIT taxable
income," as adjusted, we will be subject to tax on the undistributed
amount at regular corporate tax rates;

- we may be subject to the "alternative minimum tax" on certain items of
tax preference to the extent that tax exceeds our regular tax;

- if we have net income from the sale or other disposition of "foreclosure
property" that is held primarily for sale to customers in the ordinary
course of business or other non-qualifying income from foreclosure
property, we will be subject to tax at the highest corporate rate on such
income;

- any net income from prohibited transactions (which are, in general, sales
or other dispositions of property held primarily for sale to customers in
the ordinary course of business, other than dispositions of foreclosure
property and dispositions of property due to an involuntary conversion)
will be subject to a 100% tax;

- if we fail to satisfy either the 75% or 95% gross income tests (as
discussed below), but nonetheless maintain our qualification as a REIT
because certain other requirements are met, we will be subject to a 100%
tax on an amount equal to (1) the gross income attributable to the
greater of the amounts by which we failed the 75% or 95% test, multiplied
by (2) a fraction intended to reflect our profitability;

- if we fail to distribute during each year at least the sum of (1) 85% of
our REIT ordinary income for such year, (2) 95% of our REIT capital gain
net income for such year (other than capital gain that we elect to retain
and pay tax on) and (3) any undistributed taxable income from preceding
periods, we will be subject to a 4% excise tax on the excess of such
required distribution over amounts actually distributed; and

- we will also be subject to a tax of 100% on the amount of any rents from
real property, deductions or excess interest paid to us by any of our
"taxable REIT subsidiaries" that would be reduced through reapportionment
under certain federal income tax principles in order to more clearly
reflect income of the taxable REIT subsidiary. See "-- Qualification as a
REIT -- Investments in Taxable REIT Subsidiaries."

If we acquire any assets from a corporation which is or has been a "C"
corporation in a carryover basis transaction, we could be liable for specified
liabilities that are inherited from the "C" corporation. A "C" corporation is
generally defined as a corporation that is required to pay full corporate level
federal income tax. If we recognize gain on the disposition of such assets
during the 10-year period beginning on the date on which such assets were
acquired by us, then to the extent of such assets' "built-in gain" (i.e., the
excess of the fair market value of such asset over the adjusted tax basis in
such asset, in each case determined as of the beginning of the 10-year period),
we will be subject to tax on such gain at the highest regular corporate rate
applicable. The results described in this paragraph with respect to the
recognition of built-in gain assume that the built-in gain assets, at the time
such built-in gain assets were subject to a conversion transaction where a "C"
corporation elected REIT status or a REIT acquired such assets from a "C"
corporation, were not treated as sold to an unrelated party and that no gain was
recognized.

Qualification as a REIT

A REIT is defined as a corporation, trust or association:

(1) which is managed by one or more trustees or directors;

(2) the beneficial ownership of which is evidenced by transferable shares
or by transferable certificates of beneficial interest;

(3) which would be taxable as a domestic corporation but for the federal
income tax law relating to REITs;

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(4) which is neither a financial institution nor an insurance company;

(5) the beneficial ownership of which is held by 100 or more persons in
each taxable year of the REIT except for its first taxable year;

(6) not more than 50% in value of the outstanding stock of which is owned
during the last half of each taxable year, excluding its first taxable
year, directly or indirectly, by or for five or fewer individuals
(which includes certain entities) (the "Five or Fewer Requirement");
and

(7) which meets certain income and asset tests described below.

Conditions (1) to (4), inclusive, must be met during the entire taxable
year and condition (5) must be met during at least 335 days of a taxable year of
12 months or during a proportionate part of a taxable year of less than 12
months. For purposes of conditions (5) and (6), pension funds and certain other
tax-exempt entities are treated as individuals, subject to a "look-through"
exception in the case of condition (6).

Based on publicly available information, we believe we have satisfied the
share ownership requirements set forth in (5) and (6) above. In addition,
Article VI of our Amended and Restated By-Laws provides for restrictions
regarding ownership and transfer of shares. These restrictions are intended to
assist us in continuing to satisfy the share ownership requirements described in
(5) and (6) above. These restrictions, however, may not ensure that we will, in
all cases, be able to satisfy the share ownership requirements described in (5)
and (6) above.

We have complied with, and will continue to comply with, regulatory rules
to send annual letters to certain of our stockholders requesting information
regarding the actual ownership of our stock. If despite sending the annual
letters, we do not know, or after exercising reasonable diligence would not have
known, whether we failed to meet the Five or Fewer Requirement, we will be
treated as having met the Five or Fewer Requirement. If we fail to comply with
these regulatory rules, we will be subject to a monetary penalty. If our failure
to comply was due to intentional disregard of the requirement, the penalty would
be increased. However, if our failure to comply were due to reasonable cause and
not willful neglect, no penalty would be imposed.

We may own a number of properties through wholly owned subsidiaries. A
corporation will qualify as a "qualified REIT subsidiary" if 100% of its stock
is owned by a REIT and the REIT does not elect to treat the subsidiary as a
taxable REIT subsidiary. A "qualified REIT subsidiary" will not be treated as a
separate corporation, and all assets, liabilities and items of income,
deductions and credits of a "qualified REIT subsidiary" will be treated as
assets, liabilities and items (as the case may be) of the REIT. A "qualified
REIT subsidiary" is not subject to federal income tax, and our ownership of the
voting stock of a qualified REIT subsidiary will not violate the restrictions
against ownership of securities of any one issuer which constitute more than 10%
of the value or total voting power of such issuer or more than 5% of the value
of our total assets, as described below under "-- Asset Tests."

If we invest in a partnership, a limited liability company or a trust taxed
as a partnership or as a disregarded entity, we will be deemed to own a
proportionate share of the partnership's, limited liability company's or trust's
assets. Likewise, we will be treated as receiving our share of the income and
loss of the partnership, limited liability company or trust, and the gross
income will retain the same character in our hands as it has in the hands of the
partnership, limited liability company or trust. These "look-through" rules
apply for purposes of the income tests and assets tests described below.

Income Tests. There are two separate percentage tests relating to our
sources of gross income that we must satisfy for each taxable year.

- at least 75% of our gross income (excluding gross income from certain
sales of property held primarily for sale) must be directly or indirectly
derived each taxable year from "rents from real property," other income
from investments relating to real property or mortgages on real property
or certain income from qualified temporary investments; and

15

- at least 95% of our gross income (excluding gross income from certain
sales of property held primarily for sale) must be directly or indirectly
derived each taxable year from any of the sources qualifying for the 75%
test and from dividends (including dividends from taxable REIT
subsidiaries), interest, gain from the sale or disposition of stock
securities and payments to us under an interest rate swap, cap agreement,
option, futures contract, forward rate agreement or any similar financial
instrument entered into by us to hedge indebtedness incurred or to be
incurred.

Rents received by us will qualify as "rents from real property" for
purposes of satisfying the gross income tests for a REIT only if several
conditions are met:

- the amount of rent must not be based in whole or in part on the income or
profits of any person, although rents generally will not be excluded
merely because they are based on a fixed percentage or percentages of
receipts or sales;

- rents received from a tenant will not qualify as rents from real property
if the REIT, or an owner of 10% or more of the REIT, also directly or
constructively owns 10% or more of such tenant, unless the tenant is our
taxable REIT subsidiary and certain other requirements are met with
respect to the real property being rented;

- if rent attributable to personal property leased in connection with a
lease of real property is greater than 15% of the total rent received
under the lease, then the portion of rent attributable to such personal
property will not qualify as "rents from real property;" and

- for rents to qualify as rents from real property, we generally must not
furnish or render services to tenants, other than through a taxable REIT
subsidiary or an "independent contractor" from whom we derive no income,
except that we may directly provide services that are "usually or
customarily rendered" in the geographic area in which the property is
located in connection with the rental of real property for occupancy
only, or are not otherwise considered "rendered to the occupant for his
convenience."

For taxable years beginning after August 5, 1997, a REIT has been permitted
to render a de minimis amount of impermissible services to tenants and still
treat amounts received with respect to that property as rent from real property.
The amount received or accrued by the REIT during the taxable year for the
impermissible services with respect to a property may not exceed 1% of all
amounts received or accrued by the REIT directly or indirectly from the
property. The amount received for any service or management operation for this
purpose shall be deemed to be not less than 150% of the direct cost of the REIT
in furnishing or rendering the service or providing the management or operation.
Furthermore, impermissible services may be furnished to tenants by a taxable
REIT subsidiary subject to certain conditions, and we may still treat rents
received with respect to the property as rent from real property.

The term "interest" generally does not include any amount if the
determination of such amount depends in whole or in part on the income or
profits of any person, although an amount generally will not be excluded from
the term "interest" solely by reason of being based on a fixed percentage of
receipts or sales.

If we fail to satisfy one or both of the 75% or 95% gross income tests for
any taxable year, we may nevertheless qualify as a REIT for such year if we are
eligible for relief. These relief provisions will be generally available if:

- our failure to meet such tests was due to reasonable cause and not due to
willful neglect;

- we attach a schedule of the sources of our income to our return; and

- any incorrect information on the schedule was not due to fraud with
intent to evade tax.

It is not now possible to determine the circumstances under which we may be
entitled to the benefit of these relief provisions. If these relief provisions
apply, a 100% tax is imposed on an amount equal to (a) the gross income
attributable to the greater of the amount by which we failed the 75% or 95%
test, multiplied by (b) a fraction intended to reflect our profitability.

16

Asset Tests. At the close of each quarter of our taxable year, we must
also satisfy several tests relating to the nature and diversification of our
assets determined in accordance with generally accepted accounting principles.
At least 75% of the value of our total assets must be represented by real estate
assets, cash, cash items (including receivables arising in the ordinary course
of our operation), government securities and qualified temporary investments.
Although the remaining 25% of our assets generally may be invested without
restriction, we are prohibited from owning securities representing more than 10%
of either the vote or value of the outstanding securities of any issuer other
than a qualified REIT subsidiary, another REIT or a taxable REIT subsidiary (the
"10% vote and value test"). Further, no more than 20% of the total assets may be
represented by securities of one or more taxable REIT subsidiaries and no more
than 5% of the value of our total assets may be represented by securities of any
non-governmental issuer other than a qualified REIT subsidiary, another REIT or
a taxable REIT subsidiary. Each of the 10% vote and value test and the 20% and
5% asset tests must be satisfied at the end of any quarter. There are special
rules which provide relief if the value related tests are not satisfied due to
changes in the value of the assets of a REIT.

Investments in Taxable REIT Subsidiaries. For taxable years beginning
after December 31, 2000, REITs may own more than 10% of the voting power and
value of securities in taxable REIT subsidiaries. We and any taxable corporate
entity in which we own an interest are allowed to jointly elect to treat such
entity as a "taxable REIT subsidiary."

Several of our subsidiaries have elected to be treated as taxable REIT
subsidiaries. Taxable REIT subsidiaries are subject to full corporate level
federal taxation on their earnings but are permitted to engage in certain types
of activities which cannot be performed directly by REITs without jeopardizing
their REIT status. Our taxable REIT subsidiaries will attempt to minimize the
amount of such taxes, but there can be no assurance whether or the extent to
which measures taken to minimize taxes will be successful. To the extent our
taxable REIT subsidiaries are required to pay federal, state or local taxes, the
cash available for distribution of dividends to us from our taxable REIT
subsidiaries will be reduced.

The amount of interest on related-party debt that a taxable REIT subsidiary
may deduct is limited. Further, a 100% tax applies to any interest payments by a
taxable REIT subsidiary to its affiliated REIT to the extent the interest rate
is not commercially reasonable. A taxable REIT subsidiary is permitted to deduct
interest payments to unrelated parties without any such restrictions.

The Internal Revenue Service may reallocate costs between a REIT and its
taxable REIT subsidiary where there is a lack of arm's length dealing between
the parties. Any deductible expenses allocated away from a taxable REIT
subsidiary would increase its tax liability. Further, any amount by which a REIT
understates its deductions and overstates those of its taxable REIT subsidiary
will, subject to certain exceptions, be subject to a 100% tax.

Additional taxable REIT subsidiary elections may be made in the future for
additional entities in which we own an interest.

Annual Distribution Requirements. In order to avoid being taxed as a
regular corporation, we are required to make distributions (other than capital
gain distributions) to our stockholders which qualify for the dividends paid
deduction in an amount at least equal to (A) the sum of (i) 90% of our "REIT
taxable income" (computed without regard to the dividends paid deduction and our
net capital gain) and (ii) 90% of the after-tax net income, if any, from
foreclosure property, minus (B) a portion of certain items of non-cash income.
Such distributions must be paid in the taxable year to which they relate, or in
the following taxable year if declared before we timely file our tax return for
such year and if paid on or before the first regular distribution payment after
such declaration. The amount distributed must not be preferential. This means
that every stockholder of the class of stock to which a distribution is made
must be treated the same as every other stockholder of that class, and no class
of stock may be treated otherwise than in accordance with its dividend rights as
a class. To the extent that we do not distribute all of our net capital gain or
distribute at least 90%, but less than 100%, of our "REIT taxable income," as
adjusted, we will be subject to tax on the undistributed amount at regular
corporate tax rates. Finally, as discussed above, we may be subject to an excise
tax if we fail

17

to meet certain other distribution requirements. We intend to make timely
distributions sufficient to satisfy these annual distribution requirements.

It is possible that, from time to time, we may not have sufficient cash or
other liquid assets to meet the 90% distribution requirement, or to distribute
such greater amount as may be necessary to avoid income and excise taxation, due
to, among other things, (a) timing differences between (i) the actual receipt of
income and actual payment of deductible expenses and (ii) the inclusion of such
income and deduction of such expenses in arriving at our taxable income, or (b)
the payment of severance benefits that may not be deductible to us. In the event
that such timing differences occur, we may find it necessary to arrange for
borrowings or, if possible, pay dividends in the form of taxable stock dividends
in order to meet the distribution requirement.

Under certain circumstances, in the event of a deficiency determined by the
Internal Revenue Service, we may be able to rectify a resulting failure to meet
the distribution requirement for a year by paying "deficiency dividends" to
stockholders in a later year, which may be included in our deduction for
distributions paid for the earlier year. Thus, we may be able to avoid being
taxed on amounts distributed as deficiency distributions; however, we will be
required to pay applicable penalties and interest based upon the amount of any
deduction taken for deficiency distributions.

Failure to Qualify as a Real Estate Investment Trust

If we fail to qualify for taxation as a REIT in any taxable year, we will
be subject to federal income tax, including any applicable alternative minimum
tax, on our taxable income at regular corporate rates. Distributions to
stockholders in any year in which we fail to qualify as a REIT will not be
deductible nor will any particular amount of distributions be required to be
made in any year. All distributions to stockholders will be taxable as ordinary
income to the extent of current and accumulated earnings and profits allocable
to such distributions and, subject to certain limitations, will be eligible for
the dividends received deduction for corporate stockholders. Unless entitled to
relief under specific statutory provisions, we also will be disqualified from
taxation as a REIT for the four taxable years following the year during which
qualification was lost. It is not possible to state whether in all circumstances
we would be entitled to such statutory relief. Failure to qualify for even one
year could result in our need to incur indebtedness or liquidate investments in
order to pay potentially significant resulting tax liabilities.

Federal Income Taxation of Stockholders

Treatment of Taxable U.S. Stockholders. The following summary applies to
you only if you are a "U.S. stockholder." A "U.S. stockholder" is a stockholder
of shares of stock who, for United States federal income tax purposes, is:

- a citizen or resident of the United States;

- a corporation, partnership or other entity created or organized in or
under the laws of the United States or of any state thereof or in the
District of Columbia, unless, in the case of a partnership, Treasury
Regulations provide otherwise;

- an estate the income of which is subject to United States federal income
taxation regardless of its source; or

- a trust whose administration is subject to the primary supervision of a
United States court and which has one or more United States persons who
have the authority to control all substantial decisions of the trust.

So long as we qualify for taxation as a REIT, distributions on shares of
our stock made out of the current or accumulated earnings and profits allocable
thereto (and not designated as capital gain dividends) will be includable as
ordinary income for federal income tax purposes. None of these distributions
will be eligible for the dividends received deduction for U.S. corporate
stockholders. Distributions that are designated as capital gain dividends will
be taxed as long-term capital gains (to the extent they do not exceed our actual
net capital

18

gain for the taxable year), without regard to the period for which you held our
stock. However, if you are a corporation, you may be required to treat a portion
of some capital gain dividends as ordinary income.

If we elect to retain and pay income tax on any net long-term capital gain,
you would include in income, as long-term capital gain, your proportionate share
of such net long-term capital gain. You would also receive a refundable tax
credit for your proportionate share of the tax paid by us on such retained
capital gains and you would have an increase in the basis of your shares of our
stock in an amount equal to your includable capital gains less your share of the
tax deemed paid.

You may not include in your federal income tax return any of our net
operating losses or capital losses. Federal income tax rules may also require
that certain minimum tax adjustments and preferences be apportioned to you. In
addition, any distribution declared by us in October, November or December of
any year on a specified date in any such month shall be treated as both paid by
us and received by you on December 31 of such year, provided that the
distribution is actually paid by us no later than January 31 of the following
year.

We will be treated as having sufficient earnings and profits to treat as a
dividend any distribution up to the amount required to be distributed in order
to avoid imposition of the 4% excise tax discussed under "-- General" and
"-- Qualification as a REIT -- Annual Distribution Requirements" above. As a
result, you may be required to treat as taxable dividends certain distributions
that would otherwise result in a tax-free return of capital. Moreover, any
"deficiency dividend" will be treated as a dividend (an ordinary dividend or a
capital gain dividend, as the case may be), regardless of our earnings and
profits. Any other distributions in excess of current or accumulated earnings
and profits will not be taxable to you to the extent such distributions do not
exceed the adjusted tax basis of your shares of our stock. You will be required
to reduce the tax basis of your shares of our stock by the amount of such
distributions until such basis has been reduced to zero, after which such
distributions will be taxable as capital gain, if the shares of our stock are
held as a capital asset. The tax basis as so reduced will be used in computing
the capital gain or loss, if any, realized upon sale of the shares of our stock.
Any loss upon a sale or exchange of shares of our stock which were held for six
months or less (after application of certain holding period rules) will
generally be treated as a long-term capital loss to the extent you previously
received capital gain distributions with respect to such shares of our stock.

Upon the sale or exchange of any shares of our stock to or with a person
other than us or a sale or exchange of all shares of our stock (whether actually
or constructively owned) with us, you will generally recognize capital gain or
loss equal to the difference between the amount realized on such sale or
exchange and your adjusted tax basis in such shares of our stock. Such gain will
be capital gain if you held such shares of our stock as a capital asset.

Gain from the sale or exchange of our shares held for more than one year is
taxed at a maximum long-term capital gain rate, which is currently 15%. Pursuant
to Internal Revenue Service guidance, we may classify portions of our capital
gain dividends as gains eligible for the long-term capital gains rate or as gain
taxable to individual stockholders at a maximum rate of 25%.

Treatment of Tax-Exempt U.S. Stockholders. Tax-exempt entities, including
qualified employee pension and profit sharing trusts and individual retirement
accounts ("Exempt Organizations"), generally are exempt from federal income
taxation. However, they are subject to taxation on their unrelated business
taxable income ("UBTI"). The Internal Revenue Service has issued a published
revenue ruling that dividend distributions from a REIT to an exempt employee
pension trust do not constitute UBTI, provided that the shares of the REIT are
not otherwise used in an unrelated trade or business of the exempt employee
pension trust. Based on this ruling, amounts distributed by us to Exempt
Organizations generally should not constitute UBTI. However, if an Exempt
Organization finances its acquisition of the shares of our stock with debt, a
portion of its income from us will constitute UBTI pursuant to the "debt
financed property" rules. Likewise, a portion of its income from us would
constitute UBTI if we held a residual interest in a real estate mortgage
investment conduit.

In addition, in certain circumstances, a pension trust that owns more than
10% of our stock is required to treat a percentage of our dividends as UBTI.
This rule applies to a pension trust holding more than 10% of our

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stock only if (i) the percentage of our income that is UBTI (determined as if we
were a pension trust) is at least 5%, (ii) we qualify as a REIT by reason of the
modification of the Five or Fewer Requirement that allows beneficiaries of the
pension trust to be treated as holding shares in proportion to their actuarial
interests in the pension trust, and (iii) either (a) one pension trust owns more
than 25% of the value of our stock or (b) a group of pension trusts individually
holding more than 10% of the value of our stock collectively own more than 50%
of the value of our stock.

Backup Withholding and Information Reporting. Under certain circumstances,
you may be subject to backup withholding at applicable rates on payments made
with respect to, or cash proceeds of a sale or exchange of, shares of our stock.
Backup withholding will apply only if you:

- fail to furnish the person required to withhold with your taxpayer
identification number ("TIN");

- furnish an incorrect TIN;

- are notified by the Internal Revenue Service that you have failed to
properly report payments of interest and dividends; or

- under certain circumstances, fail to certify, under penalty or perjury,
that you have furnished a correct TIN and have not been notified by the
Internal Revenue Service that you are subject to backup withholding for
failure to report interest and dividend payments.

Backup withholding will not apply with respect to payments made to certain
exempt recipients, such as corporations and tax-exempt organizations. You should
consult with a tax advisor regarding qualification for exemption from backup
withholding, and the procedure for obtaining such exemption. Backup withholding
is not an additional tax. Rather, the amount of any backup withholding with
respect to payment to a stockholder will be allowed as a credit against such
stockholder's United States federal income tax liability and may entitle such
stockholder to a refund, provided that the required information is provided to
the Internal Revenue Service. In addition, withholding a portion of capital gain
distributions made to stockholders may be required for stockholders who fail to
certify their non-foreign status.

Taxation of Foreign Stockholders. The following summary applies to you
only if you are a foreign person. The federal taxation of foreign persons is a
highly complex matter that may be affected by many considerations.

Distributions to you of cash generated by our real estate operations, but
not by the sale or exchange of our capital assets, generally will be subject to
U.S. withholding tax at a rate of 30%, unless an applicable tax treaty reduces
that tax and you file with us the required form evidencing such lower rate.

In general, you will be subject to United States federal income tax on a
graduated rate basis rather than withholding with respect to your investment in
our stock if such investment is "effectively connected" with your conduct of a
trade or business in the United States. A corporate foreign stockholder that
receives income that is, or is treated as, effectively connected with a United
States trade or business may also be subject to the branch profits tax, which is
payable in addition to regular United States corporate income tax. The following
discussion will apply to foreign stockholders whose investment in us is not so
effectively connected. We expect to withhold United States income tax, as
described below, on the gross amount of any distributions paid to you unless (i)
you file an Internal Revenue Service Form W-8ECI with us claiming that the
distribution is "effectively connected" or (ii) certain other exceptions apply.

Distributions by us that are attributable to gain from the sale or exchange
of a United States real property interest will be taxed to you under the Foreign
Investment in Real Property Tax Act of 1980 ("FIRPTA") as if such distributions
were gains "effectively connected" with a United States trade or business.
Accordingly, you will be taxed at the normal capital gain rates applicable to a
U.S. stockholder on such amounts, subject to any applicable alternative minimum
tax and a special alternative minimum tax in the case of nonresident alien
individuals. Distributions subject to FIRPTA may also be subject to a branch
profits tax in the hands of a corporate foreign stockholder that is not entitled
to treaty exemption.

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We will be required to withhold from distributions subject to FIRPTA, and
remit to the Internal Revenue Service, 35% of designated capital gain dividends,
or, if greater, 35% of the amount of any distributions that could be designated
as capital gain dividends. In addition, if we designate prior distributions as
capital gain dividends, subsequent distributions, up to the amount of such prior
distributions not withheld against, will be treated as capital gain dividends
for purposes of withholding.

Unless our shares constitute a "United States real property interest"
within the meaning of FIRPTA or are effectively connected with a U.S. trade or
business, a sale of such shares by you generally will not be subject to United
States taxation. Our shares will not constitute a United States real property
interest if we qualify as a "domestically controlled REIT." We do, and expect to
continue to, qualify as a domestically controlled REIT. A domestically
controlled REIT is a REIT in which at all times during a specified testing
period less than 50% in value of its shares is held directly or indirectly by
foreign stockholders. However, if you are a nonresident alien individual who is
present in the United States for 183 days or more during the taxable year and
certain other conditions apply, you will be subject to a 30% tax on such capital
gains. In any event, a purchaser of our shares from you will not be required
under FIRPTA to withhold on the purchase price if the purchased shares are
"regularly traded" on an established securities market or if we are a
domestically controlled REIT. Otherwise, under FIRPTA, the purchaser may be
required to withhold 10% of the purchase price and remit such amount to the
Internal Revenue Service.

Backup withholding tax and information reporting will generally not apply
to distributions paid to you outside the United States that are treated as (i)
dividends to which the 30% or lower treaty rate withholding tax discussed above
applies; (ii) capital gains dividends; or (iii) distributions attributable to
gain from the sale or exchange by us of U.S. real property interests. Payment of
the proceeds of a sale of stock within the United States or conducted through
certain U.S. related financial intermediaries is subject to both backup
withholding and information reporting unless the beneficial owner certifies
under penalties of perjury that he or she is not a U.S. person (and the payor
does not have actual knowledge that the beneficial owner is a U.S. person) or
the stockholder otherwise established an exemption. You may obtain a refund of
any amounts withheld under the backup withholding rules by filing the
appropriate claim for refund with the Internal Revenue Service.

Potential Legislation or Other Actions Affecting Tax Consequences

Current and prospective stockholders should recognize that the present
federal income tax treatment of an investment in us may be modified by
legislative, judicial or administrative action at any time and that any such
action may affect investments and commitments previously made. The rules dealing
with federal income taxation are constantly under review by persons involved in
the legislative process and by the Internal Revenue Service and the Treasury
Department, resulting in revisions of regulations and revised interpretations of
established concepts as well as statutory changes. Revisions in federal tax laws
and interpretations of these laws could adversely affect the tax consequences of
an investment in us. Current and prospective investors should also consult their
own tax advisors regarding the effect of state, local and foreign tax laws on an
investment in us.

INTERNET ACCESS TO OUR SEC FILINGS

Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K and amendments to those reports, as well as our proxy
statements and other materials that are filed with, or furnished to, the
Securities and Exchange Commission are made available, free of charge, on our
Internet Web site at www.hcreit.com, as soon as reasonably practicable after
they are filed with, or furnished to, the Securities and Exchange Commission.

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SUBSIDIARIES AND AFFILIATES

We have formed subsidiaries in connection with our real estate
transactions. As of March 11, 2004, our wholly-owned subsidiaries consisted of
the following entities:

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ITEM 2. PROPERTIES

Our headquarters are currently located at One SeaGate, Suite 1500, Toledo,
Ohio 43604. The following table sets forth certain information regarding the
facilities that comprise our investments as of December 31, 2003:

- ---------------

(1) Investments include real estate investments and credit enhancements which
amounted to $2,000,271,000 and $3,195,000, respectively.

(2) Reflects contract rate of annual straight-line rent or interest recognized.

ITEM 3. LEGAL PROCEEDINGS

On November 20, 2002, Doctors Community Health Care Corporation and five
subsidiaries ("Doctors") filed for Chapter 11 bankruptcy protection in the
United States Bankruptcy Court for the District of Columbia. Doctors stated that
its bankruptcy filing was due to the bankruptcy of National Century Financial
Enterprises and affiliates, which halted payments to health care providers,
including Doctors. We have provided mortgage financing to Doctors in the form of
a loan secured by the Pacifica Hospital of the Valley in Sun Valley, CA, and the
other assets of the Pacifica of the Valley Corporation, one of the debtor
subsidiaries. The outstanding principal balance of the loan was approximately
$18,797,000 on December 31, 2003.

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Pursuant to procedures approved by the bankruptcy court, the assets of Doctors
were the subject of an auction held on December 10 through December 16, 2003. At
the conclusion of that auction, the debtors' independent director declared
certain members of Doctors' management the winning bidder. Their bid
contemplates a reorganization of Doctors and its subsidiaries with new equity
and debt capitalization. The results of this auction are subject to bankruptcy
court approval, which the debtors have stated they intend to seek in connection
with a hearing on the confirmation of the debtors' proposed plan of
reorganization. Doctors anticipates that this hearing should occur in March or
April 2004. Doctors did not make an interest payment for the twelve months ended
December 31, 2003. We will not recognize any interest on the loan until payment
is received.

Alterra Healthcare Corporation ("Alterra") filed for Chapter 11 bankruptcy
protection on January 23, 2003 in the United States Bankruptcy Court for the
District of Delaware. We have a master lease with Alterra for 45 assisted living
facilities with a depreciated book value of $103,293,000 at December 31, 2003. A
joint venture between Fortress Investment Group LLC and Emeritus Corporation was
the winning bidder at a bankruptcy auction held on July 17, 2003. The bankruptcy
court confirmed Alterra's plan of reorganization on November 26, 2003. In
connection with confirmation of Alterra's plan, our master lease was assumed and
the acquisition of Alterra by the Fortress-Emeritus joint venture was approved.
This transaction has closed. Alterra remained current on rental payments
throughout the bankruptcy process.

From time to time, there are other various legal proceedings pending to
which we are a party or to which some of our properties are subject arising in
the normal course of business. We do not believe that the ultimate resolution of
these proceedings will have a material adverse effect on our consolidated
financial position or results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
ISSUER REPURCHASES OF EQUITY SECURITIES

The following table sets forth, for the periods indicated, the high and low
prices of our common stock on the New York Stock Exchange, as reported on the
Composite Tape and dividends paid per share. There were 5,592 stockholders of
record as of March 11, 2004.

Our Board of Directors approved a new quarterly dividend rate of $0.60 per
share of common stock per quarter, commencing with the May 2004 dividend. Our
dividend policy is reviewed annually by the Board of Directors. The declaration
and payment of quarterly dividends remains subject to the review and approval of
the Board of Directors.
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ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data for the five years ended December 31,
2003, are derived from our audited consolidated financial statements (in
thousands, except per share data).