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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2013

or

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 001-16817

FIVE STAR QUALITY CARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

400 Centre Street, Newton, Massachusetts 02458

(Address of Principal Executive Offices) (Zip Code)

(Registrant’s Telephone Number, Including Area Code): 617-796-8387

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o  No x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No x

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

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

Number of registrant’s shares of common stock, $.01 par value, outstanding as of April 14, 2014: 48,613,442.

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FIVE STAR QUALITY CARE, INC.

FORM 10-Q

SEPTEMBER 30, 2013

INDEX

As used herein the terms “we”, “us” or “our” mean Five Star Quality Care, Inc. and its consolidated subsidiaries unless the context otherwise requires.

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Part I.    Financial Information

Item 1.  Condensed Consolidated Financial Statements

FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 (in thousands, except per share data)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

 (in thousands)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Note 1.  Basis of Presentation and Organization

General

The accompanying condensed consolidated financial statements of Five Star Quality Care, Inc. and its subsidiaries, which we refer to as we, us or our, have been prepared without audit.  Certain information and disclosures required by U.S. generally accepted accounting principles for complete financial statements have been condensed or omitted.  We believe the disclosures made are adequate to make the information presented not misleading.  However, the accompanying financial statements should be read in conjunction with the financial statements and notes contained in our Annual Report on Form 10-K for the year ended December 31, 2012, Items 1, 1A, 2, 6, 7, 9A and 15 of which were subsequently amended and restated to, among other things, correct errors in our accounting for income taxes.  Specifically, the accounting for income tax errors relate to, among other things, the measurement of deferred tax assets for net operating losses and tax credits and the measurement of deferred tax assets and liabilities for temporary differences related to fixed assets, intangible assets and investments.  In addition, as part of the restatement we have corrected certain other errors related to insurance receivables, security deposits, accrual of fixed asset additions, classification of senior living operating expenses, and certain other immaterial items.  We have also corrected the footnote presentation in Note 6 of certain of our available for sale debt securities from Level 1 assets to Level 2 assets as defined in the fair value hierarchy. Those amended and restated items, including our restated financial statements for the years ended December 31, 2012 and 2011 and related interim periods, are included in our Amendment No. 1 to our Annual Report on Form 10-K/A for the year ended December 31, 2012, which was filed with the Securities and Exchange Commission, or SEC, on April 15, 2014.  We refer in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2013, or this Quarterly Report, to our Annual Report on Form 10-K for the year ended December 31, 2012, as amended and restated in part by our Amendment No. 1 to our Annual Report on Form 10-K/A for the year ended December 31, 2012, as our Annual Report.  We have also restated our condensed consolidated financial statements for the quarters ended March 31, 2013 and June 30, 2013, and those restated financial statements are included in our Amendment No.1 to each of our Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2013 and June 30, 2013, respectively.  In the opinion of our management, all adjustments, which include only normal recurring adjustments, considered necessary for a fair presentation have been included.  All material intercompany transactions and balances with or among our consolidated subsidiaries have been eliminated.  Our operating results for interim periods are not necessarily indicative of the results that may be expected for the full year.

We operate senior living communities, including independent living communities, assisted living communities and skilled nursing facilities, or SNFs.  As of September 30, 2013, we operated 251 senior living communities (excluding those senior living communities we have classified as discontinued operations) located in 31 states containing 29,743 living units, including 220 primarily independent and assisted living communities with 26,921 living units and 31 SNFs with 2,822 living units.  As of September 30, 2013, we owned and operated 30 communities (2,946 living units), we leased and operated 181 communities (20,026 living units) and we managed 40 communities (6,771 living units).  These 251 senior living communities included 10,368 independent living apartments, 14,119 assisted living suites and 5,256 skilled nursing units.  We have excluded from the amounts above 48 living units of one senior living community that has been temporarily closed for renovations, but that senior living community is included in the 251 total senior living communities referenced above.  We have classified as discontinued operations one assisted living community owned and operated by us containing 32 living units as well as six SNFs and four assisted living communities we lease from Senior Housing Properties Trust or its subsidiaries, or SNH, and operate containing 712 living units; the 251 total senior living communities referenced above excludes these 11 communities classified as discontinued operations.

As of September 30, 2013, we also leased from SNH and operated two rehabilitation hospitals with 321 available beds that provide in-patient rehabilitation services to patients at the two hospitals and at three satellite locations.  In addition, as of that date, we leased and operated 13 out-patient clinics affiliated with these rehabilitation hospitals.  On December 31, 2013, we transferred the operations of these rehabilitation hospitals and the affiliated clinics to a third party in connection with SNH’s sale of the real estate associated with these rehabilitation hospitals.  We have classified our rehabilitation hospital business as discontinued operations as of the quarter ended September 30, 2013 (see Notes 9 and 10).

Restatement of Previously Issued Financial Statements

As discussed further in Note 12, we are restating our condensed consolidated financial statements for the three and nine months ended September 30, 2012 and for the year ended December 31, 2012, to correct certain errors in the accounting for income taxes. In addition, as part of the restatement we have corrected certain other errors related to insurance receivables, security deposits, accrual of fixed asset additions, classification of senior living operating expenses and certain other immaterial items. We corrected the presentation and disclosure of our consolidated statements of cash flows to separately identify the net cash flows from discontinued operations, by category and in total. We have also corrected the footnote presentation of certain of our available for sale debt securities from Level 1 assets to Level 2 assets as defined in the fair value hierarchy and corrected the disclosure of the fair value of our mortgage notes payable.

Recently Issued Accounting Pronouncements

In April 2014, the FASB issued Accounting Standards Update 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, or ASU 2014-08.  ASU 2014-08 changes the criteria for reporting a discontinued operation.  Under the new pronouncement, a disposal of a part of an organization that has a major effect on its operations and financial results is a discontinued operation.  We are required to adopt ASU 2014-08 prospectively for all disposals or components of our business classified as held for sale during fiscal periods beginning after December 15, 2014 and are currently evaluating what impact, if any, its adoption will have to the presentation of our condensed consolidated financial statements.

Segment Information

We have three operating segments: senior living communities, rehabilitation and wellness and rehabilitation hospitals. In the senior living community segment, we operate for our own account or manage for the account of SNH independent living communities, assisted living communities and SNFs that are subject to centralized oversight and provide housing and services to elderly residents. Our rehabilitation and wellness operating segment does not meet any of the quantitative thresholds of a reportable segment as prescribed under Financial Accounting Standards Board, or FASB, Accounting Standards CodificationTM, or ASC, Topic 280, and as discussed further in Note 10, our rehabilitation hospital operating segment has been reclassified as discontinued operations. After the reclassification of our rehabilitation hospital business as discontinued operations, our business is comprised of one reportable segment, senior living.  All of our operations and assets are located in the United States, except for the operations of our captive insurance company subsidiary, which participates in our workers’ compensation, professional liability and automobile insurance programs and which is organized in the Cayman Islands.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Note 2. Property and Equipment

Property and equipment, at cost, consists of the following:

We recorded depreciation expense of $6,442 and $5,889 for the three months ended September 30, 2013 and 2012, respectively, and $18,824 and $16,884 for the nine months ended September 30, 2013 and 2012, respectively, relating to our property and equipment.

As of September 30, 2013, we had $4,870 of assets included in our property and equipment that we expected to request that SNH purchase from us for an increase in future rent pursuant to the terms of our leases with SNH; however, we are not obligated to make these sales and SNH is not obligated to purchase those assets.

Note 3. Accumulated Other Comprehensive Income

The following table details the changes in accumulated other comprehensive income, net of tax, for the nine months ended September 30, 2013:

Accumulated other comprehensive income represents the unrealized appreciation of our investments, net of tax, and our share of other comprehensive income of Affiliates Insurance Company, or AIC.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Note 4.  Income Taxes

For the nine months ended September 30, 2013, we recognized tax expense from continuing operations of $582, which includes a tax benefit of $1,468 related to the work opportunity tax credit program that expired in 2012 and was retroactively reinstated on January 3, 2013 and extended by the American Taxpayer Relief Act of 2012, which was enacted on January 2, 2013.  As prescribed by FASB ASC Topic 740, Accounting for Income Taxes, the effects of tax law changes are recognized in the period in which new legislation is enacted.  The total effect of the reinstatement of work opportunity tax credits related to 2012 employee wages was required to be recorded as a component of income tax expense in continuing operations during the first quarter of 2013.  For the nine months ended September 30, 2013, we also recognized a tax benefit from discontinued operations of $2,157.  As of December 31, 2012, our federal net operating loss carry forward, which begins to expire in 2026 if unused, was approximately $70,765, and our tax credit carry forward, which begins to expire in 2022 if unused, was approximately $11,729.  Our net operating loss carry forwards and tax credit carry forwards may be subject to audit and adjustments by the Internal Revenue Service.

We maintain a partial valuation allowance against our state net operating losses and certain deferred tax assets related to impaired investments.  When we believe that we will more likely than not realize the benefit of these deferred tax assets, we will record deferred tax assets as an income tax benefit in our condensed consolidated statements of income, which will affect our results of operations.

Note 5.  Earnings Per Share

We computed basic earnings per common share, or EPS, for the three and nine months ended September 30, 2013 and 2012 using the weighted average number of shares of our common stock, $.01 par value per share, or our common shares, outstanding during the periods.  Diluted EPS reflects the more dilutive earnings per common share amount calculated using the two-class method or the treasury stock method. The treasury stock method reflects dilutive potential common shares related to the Notes that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income applicable to common shareholders that would result from their assumed issuance.  The weighted average shares outstanding used to calculate basic and diluted EPS include 540 and 553 unvested common shares as of September 30, 2013 and 2012, respectively, issued to our officers and others under our equity compensation plan, or the Share Award Plan.  Unvested shares issued under the Share Award Plan are deemed participating securities because they participate equally in earnings with all of our other common shares.

The following table provides a reconciliation of income from continuing operations to diluted income (loss) from discontinued operations and a reconciliation of the number of common shares used in the computations of EPS from continuing operations to diluted EPS from continuing operations and diluted loss per share from discontinued operations:

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Note 6.  Fair Values of Assets and Liabilities

Our assets recorded at fair value have been categorized based upon a fair value hierarchy in accordance with ASC Topic 820.  We apply the following fair value hierarchy, which prioritizes the inputs used to measure fair value into three levels.

Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that we have the ability to access at the measurement date.

Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs include quoted prices for similar assets and liabilities in active markets and quoted prices in inactive markets.

Level 3 inputs are unobservable inputs for the asset or liability in which there is little, if any, market activity for the asset or liability at the measurement date. 

The table below presents the assets measured at fair value at September 30, 2013 and December 31, 2012 categorized by the level of inputs used in the valuation of each asset.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

(1) Cash equivalents, consisting of money market funds held principally for obligations arising from our self-insurance programs.

(2) Investments in available for sale securities are reported on our balance sheet as current and long term investments in available for sale securities and are reported at fair value of $19,042 and $11,597, respectively, at September 30, 2013 and $12,920 and $10,580, respectively, at December 31, 2012.  We estimate the fair value of our available for sale securities by reviewing each security’s current market price, the ratings of the security, the financial condition of the issuer and our intent and ability to retain the investment during temporary market price fluctuations or until maturity.   In evaluating the factors described above, we presume a decline in value to be an “other than temporary impairment” if the quoted market price of the security is below the security’s cost basis for an extended period.  However, this presumption may be overcome if there is persuasive evidence indicating the value decline is temporary in nature, such as when the operating performance of the obligor is strong or if the market price of the security is historically volatile.  Additionally, there may be instances in which impairment losses are recognized even if the decline in value does not fall within the criteria described above, such as if we plan to sell the security in the near term and the fair value is below our cost basis.  When we believe that a change in fair value of an available for sale security is temporary, we record a corresponding credit or charge to other comprehensive income for any unrealized gains and losses.  When we determine that an impairment in the fair value of an available for sale security is an “other than temporary impairment”, we record a charge to earnings.

(3) The investment strategy of this fund is to invest principally in fixed income securities.  The fund invests in such securities or investment vehicles as it considers appropriate to achieve the fund’s investment objective, which is to provide an above average rate of total return while attempting to limit investment risk by investing in a diversified portfolio of U.S.dollar investment grade fixed income securities. There are no unfunded commitments and the investment can be redeemed weekly.

(4) The investment strategy of this fund is to invest principally in fixed income securities.  The fund invests in such securities or investment vehicles as it considers appropriate to achieve the fund’s investment objective, which is to provide an above average rate of total return while attempting to limit investment risk by investing in a diversified portfolio of primarily fixed income securities issued by companies with below investment grade ratings.  There are no unfunded commitments and the investment can be redeemed weekly.

Our investments in available for sale securities had amortized costs of $28,974 and $21,720 as of September 30, 2013 and December 31, 2012, respectively, had unrealized gains of $1,947 and $2,050 as of September 30, 2013 and December 31, 2012, respectively, and had unrealized losses of $282 and $270 as of September 30, 2013 and December 31, 2012, respectively.  At September 30, 2013, 37 of the securities we hold, with a fair value of $5,391, have been in a loss position for less than 12 months.  At September 30, 2013, none of the securities we hold have been in a loss position for 12 months or longer.  We do not believe these securities are impaired primarily because the financial conditions of the issuers of these securities remain strong with solid fundamentals, we currently intend to hold these securities until recovery and other factors that support our conclusion that the loss is temporary.  During the nine months ended September 30, 2013 and 2012, we received gross proceeds of $5,925 and $928, respectively, in connection with the sales of available for sale securities and recorded gross realized gains totaling $314 and $65, respectively, and gross realized losses totaling $308 and $3, respectively.  We record gains and losses on the sales of our available for sale securities using the specific identification method.

During the nine months ended September 30, 2013, we did not change the type of inputs used to determine the fair value of any of our assets and liabilities that we measure at fair value; however, we did correct the classification of $11,550 of our available for sale debt securities from Level 1 assets to Level 2 assets presented as of December 31, 2012 and corrected the disclosure of the fair value of our mortage notes which increased $9,947 at December 31, 2012. There were no other transfers of assets or liabilities between levels of the fair value hierarchy during the nine months ended September 30, 2013.

The carrying values of accounts receivable and accounts payable approximate fair value as of September 30, 2013 and December 31, 2012.  The carrying value and fair value of the Notes were $24,872 and $24,623, respectively, as of December 31, 2012 and were categorized in Level 2 of the fair value hierarchy in their entirety.  We estimated the fair value of the Notes using an average of the bid and ask prices of our then outstanding Notes.  The carrying value and fair value of our mortgage notes payable were $37,900 and $40,834, respectively, as of September 30, 2013 and $46,260 and $53,115 respectively, as of December 31, 2012 and are categorized in Level 3 of the fair value hierarchy in their entirety.  We estimate the fair values of our mortgage notes payable by using discounted cash flow analyses and

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

currently prevailing market terms as of the measurement date.  Because these Level 3 inputs are unobservable, our estimated fair value may differ materially from the actual fair value.  We measured the fair value of our equity investment in AIC, which is an Indiana insurance company that we currently own in equal proportion as each of the other seven shareholders of that company (see Note 9), and categorized that investment in Level 2 of the fair value hierarchy in its entirety, by considering, among other things, the individual assets and liabilities held by AIC, AIC’s overall financial condition and earning trends, and the financial condition and prospects for the insurance industry generally.

Note 7.  Indebtedness

As of September 30, 2013, we had a $35,000 revolving secured line of credit, or our Credit Agreement, available for general business purposes, including acquisitions.  On December 31, 2013, in connection with the transfer of our rehabilitation hospitals’ operations, we reduced the borrowings available under our Credit Agreement to $25,000 because the accounts receivable generated at the two rehabilitation hospitals were no longer available as collateral.  The maturity date of our Credit Agreement is March 18, 2016.  Borrowings under our Credit Agreement typically bear interest at LIBOR plus a premium of 250 basis points, or 2.68% as of September 30, 2013.  We may draw, repay and redraw funds under our Credit Agreement until maturity, and no principal repayment is due until maturity.  We made no borrowings under our Credit Agreement during the three and nine months ended September 30, 2013 and 2012.  As of April 14, 2014 and September 30, 2013, we had $0 outstanding under our Credit Agreement.  We incurred facility costs related to our Credit Agreement of $35 and $154 for the three months ended September 30, 2013 and 2012, respectively, and $277 and $509 for the nine months ended September 30, 2013 and 2012, respectively.

We are the borrower under our Credit Agreement and certain of our subsidiaries guarantee our obligations under our Credit Agreement, which is secured by our and our guarantor subsidiaries’ accounts receivable and related collateral. Our Credit Agreement provides for acceleration of payment of all amounts outstanding thereunder upon the occurrence and continuation of certain events of default, such as a change of control of us, which includes termination of our business management and shared services agreement, or our business management agreement, with Reit Management & Research LLC, or RMR.

We also have a $150,000 secured revolving credit facility, or our Credit Facility, that is available for general business purposes, including acquisitions.  The maturity date of our Credit Facility is April 13, 2015, and, subject to the payment of extension fees and meeting certain other conditions, our Credit Facility includes options for us to extend its stated maturity date for two one-year periods.  Borrowings under our Credit Facility typically bear interest at LIBOR plus a premium of 250 basis points, or 2.68% as of September 30, 2013.  We may draw, repay and redraw funds under our Credit Facility until maturity, and no principal repayment is due until maturity.  The weighted average interest rate for borrowings under our Credit Facility was 3.15% and 2.92% for the nine months ended September 30, 2013 and September 30, 2012, respectively.  As of April 14, 2014 and September 30, 2013, we had $15,000 and $10,000, respectively, outstanding under our Credit Facility.  We incurred interest expense and other associated costs related to our Credit Facility of $542 and $762 for the three months ended September 30, 2013 and 2012, respectively, and $1,442 and $1,287 for the nine months ended September 30, 2013 and 2012, respectively.

We are the borrower under our Credit Facility, and certain of our subsidiaries guarantee our obligations under our Credit Facility, which is secured by real estate mortgages on 15 senior living communities with 1,549 living units owned by our guarantor subsidiaries and our guarantor subsidiaries’ accounts receivable and related collateral.  Our Credit Facility provides for acceleration of payment of all amounts outstanding upon the occurrence and continuation of certain events of default, such as a change of control of us.

Our Credit Agreement and our Credit Facility contain a number of financial and other covenants, including covenants that restrict our ability to incur indebtedness or to pay dividends or make other distributions under certain circumstances and require us to maintain financial ratios and a minimum net worth.  Our Credit Agreement and Credit Facility require that we deliver quarterly and annual financial statements within the time periods specified within those agreements.  The lenders under each of our Credit Agreement and Credit Facility have waived, until April 15, 2014, any default resulting from our not timely delivering our financial statements for the quarter ended September 30, 2013, and until May 15, 2014, any default arising from our not timely delivering our financial statements for the year ended December 31, 2013, as required under those credit facilities.  Our financial statements for the quarter ended September 30, 2013 were delivered to our lenders contemporaneously with the filing of this Quarterly Report.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

In October 2006, we issued $126,500 principal amount of the Notes.  Our net proceeds from this issuance were approximately $122,600.  The Notes bore interest at a rate of 3.75% per annum and were convertible into our common shares at any time.  The conversion rate, which was subject to adjustment, was 76.9231 common shares per $1 principal amount of the Notes, which represented a conversion price of $13.00 per share.  The Notes were guaranteed by certain of our wholly owned subsidiaries.  The Notes were scheduled to mature on October 15, 2026.  We could prepay the Notes at any time and the holders had rights to require us to purchase all or a portion of these Notes on each of October 15, 2013, 2016 and 2021 at a repurchase price equal to 100% of the principal amount of the Notes to be repurchased, plus any accrued and unpaid interest.  We had periodically repurchased Notes in open market transactions or in privately negotiated transactions, and, on July 8, 2013, we redeemed all of the $24,872 principal amount of the Notes then outstanding at a redemption price equal to the principal amount, plus accrued and unpaid interest.  We recorded a loss on early extinguishment of debt, net of unamortized issuance costs, of $599 in the third quarter of 2013.   As of September 30, 2013 and December 31, 2012, we had $0 and $24,872, respectively, principal amount of the Notes outstanding, which were classified as current liabilities in our condensed consolidated balance sheet as of December 31, 2012.  We incurred interest expense and other associated costs related to the Notes of $21 and $245 for the three months ended September 30, 2013 and 2012, respectively, and $511 and $876 for the nine months ended September 30, 2013 and 2012, respectively.

At September 30, 2013, four of our senior living communities were encumbered by mortgage notes with an aggregate outstanding principal balance of $37,900: (1) one of our communities was encumbered by a Federal National Mortgage Association, or FNMA, mortgage note and (2) three of our communities were encumbered by Federal Home Loan Mortgage Corporation, or FMCC, mortgage notes.  These mortgages contain FNMA and FMCC, respectively, standard mortgage covenants.  We recorded a mortgage premium in connection with our assumption of the FNMA and FMCC mortgage notes as part of our acquisitions of the encumbered communities in order to record the assumed mortgage notes at their estimated fair value.  We are amortizing the mortgage premiums as a reduction of interest expense until the maturity of the respective mortgage notes.  The weighted average interest rate on these four notes was 6.91% as of September 30, 2013.  Payments of principal and interest are due monthly until maturities at varying dates ranging from June 2023 to September 2032.  We incurred mortgage interest expense, net of premium amortization, of $581 and $709 for the three months ended September 30, 2013 and 2012, respectively, and $2,425 and $2,134 for the nine months ended September 30, 2013 and 2012, respectively, including some interest expense recorded in discontinued operations.  Our mortgages require monthly payments into escrows for taxes, insurance and property replacement funds; withdrawals from these escrows require applicable FNMA and FMCC approval.  As of September 30, 2013, we believe we were in compliance with all applicable covenants under these mortgages.

In May 2011, we entered into a bridge loan, or the Bridge Loan, agreement with SNH under which SNH agreed to lend us up to $80,000 to fund a part of the purchase price for our acquisitions of certain assets of six senior living communities located in Indiana, or the Indiana Communities. During 2011, we completed our acquisitions of the assets of the Indiana Communities and, in connection with the acquisitions, borrowed $80,000 under the Bridge Loan. During 2011, we repaid $42,000 of this advance with proceeds from a public offering of our common shares and cash generated by operations. In April 2012, we repaid in full the principal amount then outstanding under the Bridge Loan, resulting in termination of the Bridge Loan. We funded the April 2012 repayment of the Bridge Loan with borrowings under our Credit Facility and cash on hand. We incurred interest expense and other associated costs related to the Bridge Loan of $314 for the nine months ended September 30, 2012.

Note 8. Off Balance Sheet Arrangements

We have pledged our accounts receivable and certain other assets, with a carrying value, as of September 30, 2013, of $12,706 arising from our operation of 26 properties owned by SNH and leased to us to secure SNH’s borrowings from its lender, FNMA.  As of September 30, 2013, we had no other off balance sheet arrangements that have had or that we expect would be reasonably likely to have a future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

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FIVE STAR QUALITY CARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Note 9. Related Person Transactions

We were formerly a 100% owned subsidiary of SNH, SNH is our largest landlord and our largest stockholder and we manage senior living communities for SNH.  In 2001, SNH distributed substantially all of our then outstanding common shares to its shareholders.  As of September 30, 2013, SNH owned 4,235 of our common shares, or approximately 8.8% of our outstanding common shares.  One of our Managing Directors, Barry Portnoy, is a managing trustee of SNH.  Barry Portnoy’s son, Adam Portnoy, also serves as a managing trustee of SNH.

As of September 30, 2013, we leased 187 senior living communities (including 10 that we have classified as discontinued operations) and two rehabilitation hospitals (which we have also classified as discontinued operations) from SNH.  Under our leases with SNH, we pay SNH minimum rent plus percentage rent based on increases in gross revenues at certain properties.  Our total minimum annual rent payable to SNH as of September 30, 2013 was $199,257, excluding percentage rent.  Our total rent expense (which includes rent for all properties we lease from SNH, including properties that we have classified as discontinued operations) under all of our leases with SNH, net of lease inducement amortization, was $50,622 and $50,119 for the three months ended September 30, 2013 and 2012, respectively, and $152,089 and $149,842 for the nine months ended September 30, 2013 and 2012, respectively.  As of September 30, 2013 and 2012, we had outstanding rent due and payable to SNH of $17,863 and $17,614, respectively.  During the nine months ended September 30, 2013, pursuant to the terms of our leases with SNH, we sold $22,501 of improvements made to properties leased from SNH, and, as a result, our annual rent payable to SNH increased by approximately $1,800.  As of September 30, 2013, our property and equipment included $4,870 for similar improvements we have made to properties we lease from SNH that we expected to request that SNH purchase from us for an increase in future rent; however, we are not obligated to make these sales and SNH is not obligated to purchase those assets.

In August 2013, we and SNH entered into an asset purchase agreement, or the Purchase Agreement, with certain unrelated third parties, pursuant to which SNH agreed to sell the real estate associated with two rehabilitation hospitals and certain related assets, and in connection with such sale, we agreed to transfer the operations of those hospitals and several leased in-patient and out-patient clinics that are affiliated with those hospitals to those third parties.  As a result of the transfer, we retained our net working capital investment in those hospitals of approximately $10,468.  Each hospital was leased to us by SNH under one of our combination leases with SNH, Lease No. 2, and the in-patient and out-patient clinics were leased to us by third parties.  In September 2013, we entered into an amendment to Lease No. 2 in connection with SNH’s agreement to sell the real estate associated with these rehabilitation hospitals and our agreement to transfer our related hospital operations.  The lease amendment provided, among other things, that effective upon the sale of the rehabilitation hospitals pursuant to the Purchase Agreement, Lease No. 2 would terminate with respect to the rehabilitation hospitals and the annual rent we pay to SNH under Lease No. 2 would be reduced by $9,500.  The lease amendment also provided for an allocation of indemnification obligations under the Purchase Agreement between SNH and us.  The transfer of the operations of the rehabilitation hospitals was completed on December 31, 2013.

We and SNH have agreed to offer for sale 10 senior living communities we lease from SNH, which we have classified as discontinued operations.  Our rent payable to SNH will be reduced if and as these sales occur pursuant to terms set in our leases with SNH.  In August 2013, SNH sold one of these communities, a SNF with 112 living units, for a sales price of $2,550, and as a result of this sale, our annual minimum rent payable to SNH decreased by $255, or 10% of the net proceeds of the sale to SNH, in accordance with the terms of the applicable lease with SNH.  In January 2014, SNH sold another one of these communities, an assisted living community with 48 living units, for a sales price of $2,400, and as a result of this sale, our annual minimum rent payable to SNH decreased by $210, or 8.75% of the net proceeds of the sale to SNH, in accordance with the terms of the applicable lease with SNH.  We can provide no assurance that the remaining eight senior living communities that we and SNH have agreed to offer for sale will be sold or what the terms of any sales may provide.

As of September 30, 2013, we managed 40 senior living communities for the account of SNH.  We manage these SNH communities pursuant to long term management agreements on substantially similar terms.  In connection with the management agreements, we and SNH have entered into four combination agreements, or pooling agreements, three pooling agreements that combine our management agreements with SNH for communities consisting only of assisted living units, or the AL Pooling Agreements, and a fourth pooling agreement, which combines our management agreements with SNH for communities that include only independent living units, or the IL Pooling Agreement.  Each of our first and second AL Pooling Agreements includes 20 identified communities (including three assisted living

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

communities that we began managing in October 2013, the management agreements for which are included under the second AL Pooling Agreement).  We and SNH entered into the third AL Pooling Agreement in November 2013 and that pooling agreement currently includes the management agreement for the community we began managing in November 2013, as further described below.  Each of the AL Pooling Agreements and the IL Pooling Agreement aggregates the determination of fees and expenses of the various communities that are subject to the applicable pooling agreement, including determinations of our incentive fees.  The senior living community in New York described below that we manage is not included in any of our Pooling Agreements.  We earned management fees from SNH of $2,290 and $1,284 for the three months ended September 30, 2013 and 2012, respectively, and $6,866 and $3,431 for the nine months ended September 30, 2013 and 2012, respectively.

In August 2013, we began managing for SNH a senior living community in Georgia with 93 assisted living units.  In October 2013, we began managing for SNH three senior living communities with an aggregate of 213 assisted living units; one of those communities is located in Tennessee, and the other two are located in Georgia.  In November 2013, we began managing for SNH a senior living community in Wisconsin with 68 assisted living units.  We entered into separate long term management agreements with SNH for each of those senior living communities on terms similar to those management agreements that we currently have with SNH for senior living communities that include assisted living units.  The management agreements for the senior living communities we began managing in August and October 2013 were added to the second AL Pooling Agreement and the management agreement for the senior living community we began managing in November 2013 was added to the third AL Pooling Agreement.  We expect that we may enter additional management arrangements with SNH for senior living communities that SNH may acquire in the future on terms similar to those management arrangements we currently have with SNH.

We manage a portion of a senior living community in New York that is not subject to the requirements of New York healthcare licensing laws, consisting of 198 living units, pursuant to a long term management agreement with SNH.  The terms of this management agreement are substantially consistent with the terms of our other management agreements with SNH for communities that include assisted living units, except that the management fee payable to us is equal to 5% of the gross revenues realized at that portion of the community, and there is no incentive fee payable to us under this management agreement.  In order to accommodate certain requirements of New York healthcare licensing laws, SNH subleases a portion of this senior living community that is subject to those requirements, consisting of 111 living units, to an entity, D&R Yonkers LLC, which is owned by SNH’s President and Chief Operating Officer and its Treasurer and Chief Financial Officer.  We manage this portion of the community pursuant to a long term management agreement with D&R Yonkers LLC.  Pursuant to that management agreement, D&R Yonkers LLC pays us a management fee equal to 3% of the gross revenues realized at that portion of the community and we are not entitled to any incentive fee under that agreement.

As discussed above in Note 7, in May 2011, we and SNH entered into the Bridge Loan, under which SNH lent to us $80,000.  In April 2012, we repaid in full the then outstanding principal amount under the Bridge Loan, resulting in the termination of the Bridge Loan.  We incurred interest expense and other associated costs on the Bridge Loan of $314 for the nine months ended September 30, 2012.

RMR provides business management and shared services to us pursuant to our business management agreement.  RMR also provides management services to SNH.  One of our Managing Directors, Barry Portnoy, is Chairman, majority owner and an employee of RMR.  Barry Portnoy’s son, Adam Portnoy, is an owner of RMR and serves as President, Chief Executive Officer and a director of RMR.  Our other Managing Director, Gerard Martin, is a director of RMR.  Bruce Mackey, our President and Chief Executive Officer, is an Executive Vice President of RMR and Paul Hoagland, our Treasurer and Chief Financial Officer, is a Senior Vice President of RMR.  SNH’s executive officers are officers of RMR and SNH’s President and Chief Operating Officer is a director of RMR.  Our Independent Directors also serve as independent directors or independent trustees of other public companies to which RMR provides management services.  Barry Portnoy serves as a managing director or managing trustee of those companies, including SNH, and Adam Portnoy serves as a managing trustee of a majority of those companies, including SNH.  In addition, officers of RMR serve as officers of those companies.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

Pursuant to our business management agreement with RMR, we recognized aggregate business management, administrative and information system service fees of $3,014 and $3,218 for the three months ended September 30, 2013 and 2012, respectively, and $10,175 and $9,696 for the nine months ended September 30, 2013 and 2012, respectively.  These amounts are included in general and administrative expenses in our condensed consolidated statements of income.  We also lease our headquarters from an affiliate of RMR for annual rent of approximately $767, which amount is subject to fixed increases.  Our rent expense for our headquarters, which included our utilities and real estate taxes that we are required to pay as additional rent, under this lease, was $355 and $359 for the three months ended September 30, 2013 and 2012, respectively, and $1,049 and $1,067 for the nine months ended September 30, 2013 and 2012, respectively.

We, RMR, SNH and five other companies to which RMR provides management services each currently own 12.5% of AIC, an Indiana insurance company.  All of our Directors, all of the trustees and directors of the other publicly held AIC shareholders and nearly all of the directors of RMR currently serve on the board of directors of AIC.  RMR provides management and administrative services to AIC pursuant to a management and administrative services agreement with AIC.

As of September 30, 2013, we have invested $5,209 in AIC since its formation in 2008.  Although we own less than 20% of AIC, we use the equity method to account for this investment because we believe that we have significant influence over AIC as all of our Directors are also directors of AIC.  Our investment in AIC had a carrying value of $5,781 and $5,629 as of September 30, 2013 and December 31, 2012, respectively.  We recognized income of $64 and $115 for the three months ended September 30, 2013 and 2012, respectively, and $219 and $236 for the nine months ended September 30, 2013 and 2012, respectively, arising from our investment in AIC. We and the other shareholders of AIC have purchased property insurance providing $500,000 of coverage pursuant to an insurance program arranged by AIC and with respect to which AIC is a reinsurer of certain coverage amounts.  This program was modified and extended in June 2013 for a one year term, and we paid a premium, including taxes and fees, of $5,428 in connection with that policy, which amount may be adjusted from time to time as we acquire or dispose of properties that are included in this program.  We periodically consider the possibilities for expanding our insurance relationships with AIC to include other types of insurance and may in the future participate in additional insurance offerings AIC may provide or arrange.  We may invest additional amounts in AIC in the future if the expansion of this insurance business requires additional capital, but we are not obligated to do so.  By participating in this insurance business with RMR and the other companies to which RMR provides management services, we expect that we may benefit financially by possibly reducing our insurance expenses or by realizing our pro rata share of any profits of this insurance business.

In July 2013, we, RMR, SNH and four other companies to which RMR provides management services purchased from an unrelated third party insurer a combined directors’ and officers’ liability insurance policy providing $10,000 of aggregate primary layer coverage and $5,000 of aggregate excess layer coverage.  We paid a premium of approximately $133 in connection with this policy.

Note 10.  Discontinued Operations

In 2011, we decided to offer for sale two SNFs we owned located in Michigan with a total of 271 living units.  On April 30, 2013, we sold these two SNFs for an aggregate sales price of $8,000, which included as part of the sales price the prepayment by the buyer of the then outstanding $7,510 of United States Department of Housing and Urban Development mortgage debt that encumbered these SNFs.

In August 2011, we agreed with SNH that SNH should sell one assisted living community we lease from SNH located in Pennsylvania with 103 living units.  We and SNH are in the process of offering this assisted living community for sale and, if sold, our annual minimum rent payable to SNH will decrease by 9.0% of the net proceeds of the sale to SNH, in accordance with the terms of our applicable lease with SNH.

In September 2012, we sold our pharmacy business to Omnicare. We received $34,298 in sale proceeds from Omnicare, including $3,789 in working capital and excluding transaction costs and taxes.  We recorded a pre-tax capital gain on the sale of the pharmacy business of $23,347.  In connection with the sale, Omnicare did not acquire the real estate we

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share data)

(unaudited)

owned associated with one pharmacy located in South Carolina.  We intend to sell this real estate and we recorded a $350 asset impairment charge during the third quarter of 2012 to reduce the carrying value of this property to its estimated fair value less costs to sell.  The fair value of assets held for sale is determined based upon the use of appraisals, input from market participants and/or our experience selling similar assets.

In June 2013, we agreed with SNH that SNH will offer for sale 10 senior living communities we lease from SNH with 721 living units.  Seven of these 10 communities with 578 living units are SNFs and three of these 10 communities with 143 living units are assisted living communities.  In August 2013, SNH sold one of these communities, a SNF with 112 living units, for a sales price of $2,550, and as a result of this sale, our annual minimum rent payable to SNH decreased by $255, or 10% of the net proceeds of the sale to SNH, in accordance with the terms of our applicable lease with SNH.  In January 2014, SNH sold another one of these communities, an assisted living community with 48 living units, for a sales price of $2,400, and as a result of this sale, our annual minimum rent payable to SNH decreased by $210, or 8.75% of the net proceeds of the sale to SNH, in accordance with the terms of the applicable lease with SNH.  We and SNH are in the process of offering the other eight communities for sale, and if sold, our annual minimum rent payable to SNH will decrease by 10% of the net proceeds of the sales to SNH, in accordance with the terms of our applicable leases with SNH.  We can provide no assurance that these eight communities will be sold or what the terms or timing for any sale of the communities may be.  We recorded a $1,231 asset impairment charge during the second quarter of 2013 to reduce the assets we own relating to these 10 communities to their estimated fair market values, less costs to sell.

Also in June 2013, we decided to offer for sale one assisted living community we own with 32 living units.  We are in the process of offering this community for sale but we can provide no assurance that this community will be sold or what the terms or timing for any sale of this community may be.

In August 2013, we and SNH entered into the Purchase Agreement with certain unrelated parties, pursuant to which SNH agreed to sell the real estate associated with two rehabilitation hospitals and certain related assets, and in connection with such sale, we agreed to transfer the operations of those hospitals and several leased in-patient and out-patient clinics that are affiliated with those hospitals to those third parties.  As of December 31, 2013, we completed the transfer of our rehabilitation hospital business, and, as a result of the transfer, we retained our net working capital investment in those hospitals of approximately $10,468 and our annual rent payable to SNH and others decreased by approximately $11,500.  We recorded a $1,029 asset impairment charge during the third quarter of 2013 to reduce the fixed assets we own relating to the rehabilitation hospitals to their estimated fair market values.

We have reclassified the condensed consolidated balance sheets, the condensed consolidated statements of income and the consolidated statement of cash flows for all periods presented to show the financial position, results of operations and cash flows of our rehabilitation hospitals, pharmacies and the communities that have been sold or are expected to be sold as discontinued.  Below is a summary of the operating results of these discontinued operations included in the condensed consolidated financial statements for the three and nine months ended September 30, 2013 and 2012: