GENERAL INDUSTRY TRENDS

The senior living industry generally is experiencing growth as a result of demographic factors. According to census data, the population in the United States over age 75 is growing much faster than the general population. A large number of independent and assisted living communities were built in the 1990s. This development activity caused an excess supply of new, high priced communities. Longer than projected fill up periods resulted in low occupancy, price discounting and financial distress for many independent and assisted living operators. Development activity was significantly reduced in the early part of this decade. We believe that the nationwide supply and demand for these types of facilities is about balanced today. We believe that the aging of the United States population and the almost complete reliance of independent and assisted living services upon revenues from residents' private resources should mean that these types of facilities can be profitably operated.

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

Beginning in 2007, problems in certain domestic credit markets presaged a global credit crisis that has led to recession in the United States and abroad. The recession has resulted in aggressive government spending in the United States, significant corporate layoffs, reduced availability of credit on reasonable terms in most markets, and lower real estate prices. At this time, the depth and duration of this recession cannot be determined. This economic weakness has dampened demand for some types of senior living communities in certain markets and our occupancy rates have modestly declined. Also, we have seen some pricing pressures from competition. At the same time, we believe our business to be inherently healthy and that the anticipated decline in senior housing construction may have an offsetting effect to any decline in demand.

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

Institutional pharmacies provide large quantities of drugs at locations where patients with recurring pharmacy requirements are concentrated. The business rationale for an institutional pharmacy is to deliver drugs and pharmacy services more efficiently and at lower costs than from expensive retail locations which cater to short term requirements. The aging of the population and recent pharmacological innovations have created rapidly growing demand for pharmacy drugs and services. The Medicare Part D prescription drug benefit was implemented in 2006 pursuant to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or MMA, and by December 2008, approximately 90% of Medicare beneficiaries had enrolled in Medicare Part D, according to the U.S. Department of Health and Human Services. In 2007, (the most recent date for which information is publicly available) the government share of all prescription drug expenditures in the United States rose to approximately 36%, including approximately 21% from the Medicare program and approximately 8% from Medicaid programs. Because the MMA has increased Medicare expenditures for prescription drugs, we anticipate that the federal government and Congress will seek to implement various cost control measures and as a result, the profitability of providing pharmacy goods and services may be reduced.

We earn our senior living revenue primarily by providing housing and services to our senior living residents. During 2008, approximately 32% of our senior living revenues came from the Medicare and Medicaid programs and approximately 68% of our senior living revenues came from residents' private resources. We bill all private pay residents in advance for the housing and services to be provided in the following month.

Our material expenses are:

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

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

º •
º Rent expense-we lease 181 of our 210 senior living communities and two rehabilitation hospitals from Senior Housing and four senior living communities from HCPI.

º •
º Hospital expenses-includes wages and benefits for our hospital based staff and other operating expenses related to our hospital business.

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

º •
º General and administrative expenses-principally wage related costs for headquarters and regional staff supporting our communities, hospitals and pharmacies.

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

º •
º Interest and other expenses-primarily includes interest on outstanding debt and amortization of deferred financing costs.

Our reportable segments consist of our senior living community business and our rehabilitation hospital business. In the senior living community segment, we operate independent living or congregate care communities, assisted living communities and SNFs. Our rehabilitation hospital segment provides inpatient health rehabilitation services at two hospital locations and three satellite locations and outpatient rehabilitation services at 15 outpatient clinics. We do not consider our pharmacy operations to be a material, separately reportable segment of our business but we report our pharmacy revenues and expense as separate items within our corporate and other activities. All of our operations and assets are located in the United States, except with regard to our two captive insurance companies which participate in our workers compensation and liability insurance programs and are located in Bermuda and the Cayman Islands.

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

Year ended December 31, 2008 versus year ended December 31, 2007

The following tables present an overview comparison of our operations for the years ended December 31, 2008 and 2007:

Senior living communities:

                                                            For the years ended December 31,
(dollars in thousands, except average daily rate)      2008         2007      $ Change     % Change
Senior living revenue                               $  935,393   $  809,934   $ 125,459         15.5 %
Senior living wages and benefits                      (467,068 )   (410,447 )   (56,621 )       13.8 %
Other senior living operating expenses                (235,603 )   (202,194 )   (33,409 )       16.5 %
Rent expense                                          (148,959 )   (118,902 )   (30,057 )       25.3 %
Depreciation and amortization                          (10,177 )     (9,386 )      (791 )        8.4 %
Interest and other expense                              (1,077 )     (1,454 )       377        (25.9 )%
Interest and other income                                  898          206         692        335.9 %
Gain on extinguishment of debt                             743        4,491      (3,748 )      (83.5 )%

Senior living income from continuing operations     $   74,150   $   72,248   $   1,902          2.6 %

No. of communities (end of period)                         210          163          47         28.8 %
No. of living units (end of period)                     22,264       18,079       4,185         23.1 %
Occupancy %                                               88.4 %       90.3 %       n/a         (1.9 )%
Average daily rate                                  $   143.08   $   137.23   $    5.85          4.3 %
Percent of senior living revenue from Medicare            14.8 %       15.5 %       n/a         (0.7 )%
Percent of senior living revenue from Medicaid            16.9 %       18.3 %       n/a         (1.4 )%
Percent of senior living revenue from private and
other sources                                             68.3 %       66.2 %       n/a          2.1 %

Comparable Communities (communities that we operated continuously since January 1, 2007):

                                                         For the years ended December 31,
(dollars in thousands, except per day amounts)      2008         2007      $ Change     % Change
Senior living revenue                            $  836,690   $  808,880   $  27,810          3.4 %
Senior living community expenses                 $ (633,224 ) $ (612,079 ) $ (21,145 )        3.5 %
No. of communities (end of period)                      162          162           -            -
No. of living units (end of period)                  18,029       18,023           6            -
Occupancy %                                            88.6 %       90.4 %       n/a         (1.8 )%
Average daily rate                               $   144.45   $   137.34   $    7.11          5.2 %
Percent of senior living revenue from Medicare         16.1 %       15.5 %       n/a          0.6 %
Percent of senior living revenue from Medicaid         18.1 %       18.3 %       n/a         (0.2 )%
Percent of senior living revenue from private
and other sources                                      65.8 %       66.2 %       n/a         (0.4 )%


Rehabilitation hospitals:

                                                  For the years ended December 31,
(dollars in thousands)                       2008        2007      $ Change     % Change
Hospital revenue                           $  98,428   $ 102,005    $ (3,577 )       (3.5 )%
Hospital expenses                            (91,185 )   (92,449 )     1,264         (1.4 )%
Rent expense                                 (10,748 )   (10,288 )      (460 )        4.5 %
Impairment on long lived assets               (1,837 )         -      (1,837 )          -
Depreciation and amortization                   (943 )    (1,085 )       142        (13.1 )%

Hospital loss from continuing operations   $  (6,285 ) $  (1,817 )  $ (4,468 )      245.9 %



Corporate and Other(1):

                                               For the years ended December 31,
    (dollars in thousands)                2008        2007      $ Change     % Change
    Pharmacy revenue                    $  70,379   $  60,985   $   9,394         15.4 %
    Pharmacy expenses                     (69,535 )   (58,012 )   (11,523 )       19.9 %
    Depreciation and amortization          (3,599 )    (3,124 )      (475 )       15.2 %
    General and administrative(2)         (47,829 )   (43,373 )    (4,456 )       10.3 %
    Unrealized loss on investments in     (11,967 )         -     (11,967 )          -
    trading securities
    Unrealized gain on receipt of UBS      11,081           -      11,081            -
    put right
    Impairment of goodwill                 (5,930 )         -      (5,930 )          -
    Impairment on investments in           (8,404 )         -      (8,404 )          -
    available for sale securities
    Interest and other income               5,017       5,946        (929 )      (15.6 )%
    Interest and other expense             (5,260 )    (5,348 )        88         (1.6 )%
    Provision for income taxes             (1,392 )    (1,410 )        18         (1.3 )%

    Corporate and Other loss from       $ (67,439 ) $ (44,336 ) $ (23,103 )       52.1 %
    continuing operations

º (2)
º General and administrative expenses are not attributable to a specific segment and include items such as corporate payroll and benefits and third party service expenses.

Consolidated:

                                               For the years ended December 31,
   (dollars in thousands)                 2008         2007      $ Change     % Change
   Summary of revenue:
      Senior living revenue            $   935,393   $ 809,934   $ 125,459         15.5 %
      Hospital revenue                      98,428     102,005      (3,577 )       (3.5 )%
      Corporate and Other                   70,379      60,985       9,394         15.4 %

   Total revenue                       $ 1,104,200   $ 972,924   $ 131,276         13.5 %

   Summary of income (loss) from
   continuing operations:
      Senior living communities        $    74,150   $  72,248   $   1,902          2.6 %
      Rehabilitation hospitals              (6,285 )    (1,817 )    (4,468 )      245.9 %
      Corporate and Other                  (67,439 )   (44,336 )   (23,103 )       52.1 %

   Income from continuing operations   $       426   $  26,095   $ (25,669 )      (98.4 )%

Year ended December 31, 2008, Compared to year ended December 31, 2007

Senior living communities:

The 15.5% increase in senior living revenues for the year ended December 31, 2008 was due primarily to revenues from the 47 communities we began to operate in 2008 and increased per diem charges, partially offset by a decrease in occupancy. The 3.4% increase in senior living revenue at the communities that we have operated continuously since January 1, 2007 was due primarily to increased per diem charges to residents, partially offset by a decrease in occupancy.

Our 13.8% increase in senior living wages and benefits costs for the year ended December 31, 2008 was primarily due to wages and benefits at the 47 communities we began to operate in 2008 and wage increases. The 16.5% increase in other senior living operating expenses, which include utilities, housekeeping, dietary, maintenance, insurance and community level administrative costs, primarily results from the operating expenses at the 47 communities we began to operate in 2008 and increased charges from third parties. The senior living community expenses for the senior living communities that we have operated continuously since January 1, 2007 have increased by 3.5%, due primarily to increases in wages and benefits and utility expenses. The 25.3% rent expense increase was due to the 37 communities that we began to lease during 2008 and our payment of additional rent for senior living community capital improvements purchased by Senior Housing since January 1, 2007.

The 8.4% increase in depreciation and amortization for the year ended December 31, 2008 was primarily attributable to our purchase of furniture and fixtures for our owned communities.

Our interest and other income increased by $692,000, or 335.9%, for the year ended December 31, 2008, primarily as a result of recognition of an $840,000 gain related to the 2003 sale of a property that was previously deferred until the buyer paid in full our note receivable related to the sale during the first quarter of 2008.

Our interest and other expense decreased by 25.9%, for the year ended December 31, 2008, primarily due to our September 2008 prepayment of two United States Department of Housing, or HUD, insured mortgages secured by one of our communities. We paid $2.4 million in principal and interest to retire these two mortgages. Because we had recorded these mortgages at a premium to their face value, we recognized a gain of $743,000 in connection with this early extinguishment of debt.

Rehabilitation hospitals:

The 3.5% decrease in hospital revenues for the year ended December 31, 2008 was primarily due to lower Medicare reimbursement rates as well as the closing of several unprofitable outpatient clinics

offset by a slight increase in occupancy. We are currently experiencing losses from our operation of our hospitals and we may be unable to operate these hospitals profitably. Sixty percent (60%) of the patients at our hospitals are required to meet certain Medicare criteria related to their need for inpatient rehabilitation services. We believe that we are in compliance with these current Medicare requirements. Effective for discharges after April 1, 2008, Medicare inflationary rate increases for IRFs have been set at zero percent for federal fiscal years 2008 and 2009. Our hospitals had received a Medicare rate increase of 3.5% effective October 1, 2007 but their rates were reduced by 3.2% effective for discharges after April 1, 2008. Also, on July 1, 2008, CMS issued a rule updating the Medicare IRF prospective rate formulas for federal fiscal year 2009, which CMS estimated would result in a decrease of 0.7% to total Medicare payments to IRFs for the year.

The 1.4% decrease in hospital expenses for the year ended December 31, 2008 was primarily due to reductions in labor and benefit expenses and the closing of several unprofitable outpatient clinics.

The 4.5% rent expense increase in the year ended December 31, 2008 was due to our payment of additional rent for hospital capital improvements purchased by Senior Housing since January 1, 2007.

The 13.1% decrease in depreciation and amortization expense for the year ended December 31, 2008 was primarily attributable to our write off of long lived assets offset by our purchase of furniture and fixtures and information technology systems for our rehabilitation hospitals.

During our annual review of long lived and other intangible assets, we identified and recorded an impairment of long lived assets related to our two rehabilitation hospitals of $1.8 million.

Corporate and other:

The 15.4% increase in pharmacy revenues for the year ended December 31, 2008 was primarily the result of adding new customers from both our existing senior living and third party communities partially offset by the establishment of a contractual allowance reserve of $1.0 million. We recorded this allowance in order to fairly state the realizable value of our pharmacy receivables which are primarily billed under Medicare Part D.

The 19.9% increase in pharmacy expenses for the year ended December 31, 2008 was primarily due to adding new customers.

The 10.3% increase in general and administrative expenses for the year ended December 31, 2008 was primarily the result of the costs associated with the 47 communities we began to operate in 2008.

The 15.2% increase in depreciation and amortization expense for the year ended December 31, 2008 was primarily attributable to our purchase of furniture and fixtures and information technology systems for our pharmacies and corporate and regional offices.

During the year ended December 31, 2008, we recognized:

º •
º an unrealized loss of $12.0 million on investments in trading securities related to our holdings of ARS; º •
º an unrealized gain of $11.0 million as a result of the agreement with UBS reached in the fourth quarter of 2008 to purchase our ARS at 100% par value upon our request between June 2010 and July 2012; º •
º an impairment loss of $5.9 million of goodwill associated with our pharmacies; and º •
º an "other than temporary" loss of $8.4 million on investments in available for sale securities held by our captive insurance companies.

Our interest and other income decreased by $929,000, or 15.6%, for the year ended December 31, 2008, compared to the year ended December 31, 2007, primarily as a result of lower cash available for investment and lower interest rates earned on our cash investments.

For the year ended December 31, 2008, we recognized tax expenses of $1.4 million, which includes:

º •
º tax expense of $1.6 million for state taxes payable without regard to our tax loss carry forwards; º •
º tax expense of $129,000 related to a non-cash deferred tax liability arising from the amortization of goodwill for tax purposes but not for book purposes. Due to the impairment of certain of these related items of goodwill for book purposes, we recognized a portion of the deferred tax liability as a reduction in the income tax provision; and º •
º partially offset by a tax benefit of $(352,000) related to prior year refunds resulting from the application of tax credits that offset federal alternative minimum taxes.

Discontinued operations:

Loss from discontinued operations for the year ended December 31, 2008 increased $2.2 million to $4.9 million, compared to a loss of $2.8 million for the year ended December 31, 2007. The losses in both years are primarily due to operating expenses we incurred as a result of our shutting down operations at two communities in each of 2007 and 2006 and two pharmacies in 2007. The loss for the year ended December 31, 2008 also includes a $300,000 impairment loss of goodwill at our pharmacy located in California and the write down of fixed assets of $1.8 million at one of our assisted living communities.

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

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

Senior living communities:

                                                        For the years ended December 31,
(dollars in thousands, except per day amounts)      2007         2006      $ Change    % Change
Senior living revenue                            $  809,934   $  744,897   $  65,037         8.7 %
Senior living wages and benefits                   (410,447 )   (382,093 )   (28,354 )       7.4 %
Other senior living operating expenses             (202,194 )   (186,396 )   (15,798 )       8.5 %
Management fees to SLS                                    -       (8,744 )     8,744        (100 )%
Termination expense for certain SLS management
agreements                                                -     (129,913 )   129,913        (100 )%
Rent expense                                       (118,902 )   (106,781 )   (12,121 )      11.4 %
Depreciation and amortization                        (9,386 )     (7,704 )    (1,682 )      21.8 %
Interest and other expense                           (1,454 )     (2,768 )     1,314       (47.5 )%
Interest and other income                               206          442        (236 )     (53.4 )%
Gain on extinguishment of debt                        4,491            -       4,491           -

Senior living income from continuing
operations                                       $   72,248   $  (79,060 ) $ 151,308      (191.4 )%

No. of communities (end of period)                      161          160           1         0.6 %
No. of living units (end of period)                  17,906       17,935         (29 )      (0.2 )%
Occupancy                                              90.3 %       90.9 %       n/a        (0.6 )%
Average daily rate                               $   137.24   $   125.18   $   12.06         9.6 %
Percent of senior living revenue from Medicare         15.3 %       14.1 %       n/a         1.2 %
Percent of senior living revenue from Medicaid         18.2 %       19.4 %       n/a        (1.2 )%
Percent of senior living revenue from private
and other sources                                      66.5 %       66.5 %       n/a           -

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

                                                         For the years ended December 31,
(dollars in thousands, except per day amounts)      2007         2006      $ Change     % Change
Senior living revenue                            $  772,602   $  735,122   $  37,480          5.1 %
Senior living community expenses                 $ (581,624 ) $ (561,000 ) $ (20,624 )        3.7 %
No. of communities (end of period)                      149          149           -            -
No. of living units (end of period)                  16,594       16,594           -            -
Occupancy                                              90.8 %       91.1 %       n/a         (0.3 )%
Average daily rate                               $   140.48   $   133.23   $    7.25          5.4 %
Percent of senior living revenue from Medicare         15.8 %       14.1 %       n/a          1.7 %
Percent of senior living revenue from Medicaid         18.9 %       19.3 %       n/a         (0.4 )%
Percent of senior living revenue from private
and other sources                                      65.3 %       66.6 %       n/a         (1.3 )%


Rehabilitation hospitals:

                                                  For the years ended December 31,
 (dollars in thousands)                       2007        2006      $ Change    % Change
 Hospital revenue                           $ 102,005   $  25,494   $  76,511       300.1 %
 Hospital expenses                            (92,449 )   (22,954 )   (69,495 )     302.8 %
 Rent expense                                 (10,288 )    (2,475 )    (7,813 )     315.7 %
 Depreciation and amortization                 (1,085 )      (102 )      (983 )     963.7 %

 Hospital loss from continuing operations   $  (1,817 ) $     (37 ) $  (1,780 )   4,810.8 %



Corporate and Other(1):

                                               For the years ended December 31,
    (dollars in thousands)                2007        2006      $ Change     % Change
    Pharmacy revenue                    $  60,985   $  45,195   $  15,790         34.9 %
    Pharmacy expenses                     (58,012 )   (44,579 )   (13,433 )       30.1 %
    Depreciation and amortization          (3,124 )    (2,045 )    (1,079 )       52.8 %
    General and administrative(2)         (43,373 )   (33,829 )    (9,544 )       28.2 %
    Interest and other income               5,946       6,364        (418 )       (6.6 )%
. . .