FORM 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549(MARK ONE) |X|ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1998 OR | |TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to _____________ Commission File No. 1-9321 UNIVERSAL HEALTH REALTY INCOME TRUST (Exact name of registrant as specified in its charter) Maryland 23-6858580 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) Universal Corporate Center 367 South Gulph Road P.O. Box 61558 19406-0958 King of Prussia, Pennsylvania (Zip Code)(Address of principal executive offices) Registrant's telephone number, including area code: (610) 265-0688 Securities registered pursuant to Section 12(b) of the Act: Title of each Class Name of each exchange on which registeredShares of beneficial interest, $.01 par value New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: NoneIndicate by check mark whether the registrant (1) has filed all reports to befiled by Section 13 or 15(d) of the Securities and Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes [x] No [ ]Indicate by check mark if disclosure of delinquent filers pursuant to Item 405of Regulation S-K is not contained herein, and will not be contained, to thebest of Registrant's knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment to thisForm 10-K. | |Aggregate market value of voting shares held by non-affiliates as of January 31,1999: $168,231,750.Number of shares of beneficial interest outstanding of registrant as of January31, 1999: 8,955,465. DOCUMENTS INCORPORATED BY REFERENCEPortions of the registrant's definitive proxy statement for its 1999 AnnualMeeting of Shareholders, which will be filed with the Securities and ExchangeCommission within 120 days after December 31, 1998 (incorporated by referenceunder Part III). PART I Item 1. BUSINESS General The Trust commenced operations on December 24, 1986. As of December 31, 1998, the Trust had investments in thirty-one facilities located in fourteen states consisting of the following: Facility Name Location Type of Facility Guarantor- --------------------------------------------- ----- --------------------- ------------------------ -------------------------------- Chalmette Medical Center (A) Chalmette, LA Acute Care Universal Health Services, Inc.Virtue Street Pavilion (A) Chalmette, LA Rehabilitation Universal Health Services, Inc.Inland Valley Regional Medical Ctr. (A) Wildomar, CA Acute Care Universal Health Services, Inc.McAllen Medical Center (A) McAllen, TX Acute Care Universal Health Services, Inc.Meridell Achievement Center (A) Austin, TX Behavioral Health Universal Health Services, Inc.The Bridgeway (A) N.Little Rock, AR Behavioral Health Universal Health Services, Inc.Wellington Regional Medical Center (A) W.Palm Beach, FL Acute Care Universal Health Services, Inc.Vencor Hospital - Chicago (B) Chicago, IL Sub-Acute Care Vencor, Inc.Tri-State Rehabilitation Hospital (B) Evansville, IN Rehabilitation HEALTHSOUTH CorporationFresno Herndon Medical Plaza (B) Fresno, CA Medical Office Bldg. ---Family Doctor's Medical Office Bldg. (B) Shreveport, LA Medical Office Bldg. Columbia/HCA Healthcare Corp.Kelsey-Seybold Clinic at Kings Crossing (B) Kingwood, TX Medical Office Bldg. Caremark International, Inc.Professional Bldgs. at Kings Crossing (B) Kingwood, TX Medical Office Bldg. ---Chesterbrook Academy (B) Audubon, PA Preschool & Childcare Nobel Education Dynamics & Subs.Carefree Learning Center (B) New Britain, PA Preschool & Childcare Nobel Education Dynamics & Subs.Carefree Learning Center (B) Newtown, PA Preschool & Childcare Nobel Education Dynamics & Subs.Carefree Learning Center (B) Uwchlan, PA Preschool & Childcare Nobel Education Dynamics & Subs.Southern Crescent Center (B) Riverdale, GA Medical Office Bldg. ---Desert Samaritan Hospital MOBs (C) Phoenix, AZ Medical Office Bldg. ---Suburban Medical Center MOBs (D) Louisville, KY Medical Office Bldg. ---Maryvale Samaritan Hospital MOBs (E) Phoenix, AZ Medical Office Bldg. ---Desert Valley Medical Center MOB (F) Phoenix, AZ Medical Office Bldg. ---Thunderbird Paseo Medical Plaza (G) Glendale, AZ Medical Office Bldg. ---Cypresswood Professional Center (H) Houston, TX Medical Office Bldg. ---Samaritan West Valley Medical Ctr. (I) Goodyear, AZ MOB, Imaging Ctr. ---Edwards Medical Plaza (F) Phoenix, AZ Medical Office Bldg. ---Desert Springs Medical Plaza (J) Las Vegas, NV Medical Office Bldg. Quorum Health Group, Inc.Pacifica Palms Medical Plaza (F) Torrance, CA Medical Office Bldg. ---St. Jude Heritage Health Complex (K) Fullerton, CA Medical Office Bldg. ---Rio Rancho Medical Center (L) Rio Rancho, NM Medical Office Bldg. ---Lake Shore Hospital (M) Manchester, NH Unoccupied --- (A) Leased to subsidiaries of Universal Health Services, Inc. (B) Real estate assets owned by the Trust and leased to an unaffiliated third-party or parties. (C) The Trust has a 61% equity interest in a limited liability company ("LLC") which owns the real estate assets of this facility. (D) The Trust has a 33% equity interest in a LLC which owns the real estate assets of this facility on which construction was completed during the third quarter of 1996. In connection with this property, the Trust posted a $3.5 million standby letter of credit for the benefit of the third-party lending institution that provided financing which matures in May, 1999. (E) The Trust has a 60% interest in a LLC which owns the real estate assets of this facility. (F) The Trust has a 95% equity interest in a LLC which owns the real estate assets of this facility. (G) The Trust has a 75% equity interest in a LLC which owns the real estate assets of this facility. (H) The Trust has provided financing, which matures in August, 2002, to a limited partnership in which the Trust owns a 77% controlling interest. Construction on this facility was completed on a substantial portion of the building and the facility was opened during the third quarter of 1997. In connection with this investment, the Trust made a capital contribution of $343,000 to the limited partnership. (I) The Trust has a 89% equity interest in a LLC which owns the real estate assets of this facility. Construction was completed and the facility opened during the fourth quarter of 1997. 1 (J) The Trust has a 99% equity interest in a LLC which owns the real estate assets of this facility. (K) The Trust has a 48% equity interest in a LLC which owns the real estate assets of this facility. (L) The Trust has a 80% equity interest in a LLC which owns the real estate assets of this facility. (M) The Trust received free and clear title to the real estate assets of Lake Shore Hospital during 1995. The Trust continues to market this facility to third parties interested in purchasing or leasing the real estate assets. In this Annual Report on Form 10-K, the term "revenues" does not include the revenues of the unconsolidated limited liability companies in which the Trust has various non-controlling equity interests ranging from 33% to 99%. The Trust accounts for its share of the income/loss from these investments by the equity method. As of December 31, 1998, the Trust has invested an aggregate of $202 million in various real estate assets, mortgage loans, construction loans and limited liability companies and limited partnerships which own real estate assets. Included in the Trust's portfolio is ownership of nine hospital facilities (aggregate investment of $136 million) which contain an aggregate of 1,279 licensed beds. The leases with respect to such facilities comprised 81% of the Trust's 1998 revenues, have fixed terms with an average of 5.2 years remaining and provide for renewal options for up to six five-year terms. During 1998, wholly-owned subsidiaries of Universal Health Services, Inc. ("UHS") exercised five-year renewal options on four hospitals owned by the Trust which were scheduled to expire in 1999 through 2001. The leases on these facilities were renewed at the same lease rates and terms as the initial leases. Minimum rents are payable based on the initial acquisition costs of the facilities and, with respect to all facilities other than the one leased to Vencor Hospital - Chicago, additional rents are payable based upon a percentage of each facility's revenue in excess of base year amounts or CPI increases in excess of base year amounts. The lessees have rights of first refusal to purchase the facilities exercisable during and in most cases for 180 days after the expiration of the lease terms and also have purchase options exercisable upon three to six months notice at the end of each lease term at the facility's fair market value. Subsequent to December 31, 1998, the lease on Tri-State Rehabilitation Hospital was amended and renewed for a five-year term commencing June 1, 1999 and ending May 31, 2004. Pursuant to the terms of the lease, as amended, the minimum rent has been increased and the additional rent provision has been eliminated. For the hospital facilities owned by the Trust, the combined ratio of earnings before interest, taxes, depreciation, amortization and lease and rental expense (EBITDAR) (excluding a favorable prior year net revenue adjustment recorded during 1996 at one of the Trust's facilities) to minimum rent plus additional rent payable to the Trust was approximately 5.1, 4.7 and 5.0 for the years ended December 31, 1998, 1997 and 1996, respectively. The coverage ratio for individual facilities varies (see "Relationship to Universal Health Services, Inc."). Pursuant to the terms of the leases with subsidiaries of UHS, UHS is responsible for building operations, maintenance and renovations required at the seven hospital facilities leased from the Trust. For the Trust's multi-tenant medical office buildings, cash reserves have been established to fund required building maintenance and renovations. Lessees are required to maintain all risk, replacement cost and commercial property insurance policies on the leased properties. The Trust is one of the named insured and believes the leased properties are adequately insured. Relationship to Universal Health Services, Inc. Leases. As of December 31, 1998, subsidiaries of UHS leased seven of the nine hospital facilities owned by the Trust with terms expiring in 2000 through 2006. The leases to the subsidiaries of UHS are guaranteed by UHS and are cross-defaulted with one another. Each of the leases contains 2 renewal options of up to six five-year periods. These leases accounted for 75% of the total revenue of the Trust for the five years ended December 31, 1998 (72% for the three years ended December 31, 1998). During the third quarter of 1998, wholly-owned subsidiaries of UHS exercised five-year renewal options on four hospitals owned by the Trust which were scheduled to expire in 1999 through 2001 (Virtue Street Pavilion, The Bridgeway, Inland Valley Regional Medical Center and Wellington Regional Medical Center). The leases on these facilities were renewed at the same lease rates and terms as the initial leases and these renewals remove the majority of the previously disclosed uncertainty regarding the lease renewals with subsidiaries of UHS. As part of the renewal agreement, the Trust also agreed to grant additional fixed rate renewal options to a wholly-owned subsidiary of UHS commencing in 2022 on the real property of McAllen Medical Center. The leases on the four renewed facilities represented 30% of the Trust's rental revenue for the twelve month period ended December 31, 1998. On a combined basis, these four facilities had earnings before interest, taxes, depreciation, amortization and lease and rental expense (EBITDAR) for the twelve month period ended December 31, 1998 of 1.8 times the annual rent payable to the Trust (ranging from 1.2 to 3.0). The remaining UHS facilities, including McAllen Medical Center, had a combined EBITDAR for the twelve month period ended December 31, 1998 of 7.7 times the annual rent payable to the Trust (ranging from 1.1 to 8.6). The lease on one UHS facility, which had EBITDAR for the twelve month period ended December 31, 1998 of 1.1 times the rent payable to the Trust, expires in 2000 and represented approximately 5% of the Trust's rental revenue for the twelve month period ended December 31, 1998. Management of the Trust can not predict whether the leases with subsidiaries of UHS, which have renewal options at existing lease rates, or any of the Trust's other leases, will be renewed at the end of their initial term or first five-year renewal term. In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would effect major changes in the healthcare system, either nationally or at the state level (see "Regulation"). In addition, the healthcare industry has been characterized in recent years by increased competition and consolidation. Management of the Trust is unable to predict the effect, if any, these industry factors will have on the operating results of its lessees, including the facilities leased to subsidiaries of UHS, or on their ability to meet their obligations under the terms of their leases with the Trust. Pursuant to the terms of the leases with UHS, the lessees have rights of first refusal to: (i) purchase the respective leased facilities during and for 180 days after the lease terms at the same price, terms and conditions of any third-party offer, or; (ii) renew the lease on the respective leased facility at the end of, and for 180 days after, the lease term at the same terms and conditions pursuant to any third-party offer. The leases also grant the lessees options, exercisable on at least six months notice, to purchase the respective leased facilities at the end of the lease term or any renewal term at the facility's then fair market value. The terms of the leases also provide that in the event UHS discontinues operations at the leased facility for more than one year, or elects to terminate its lease prior to the expiration of its term for prudent business reasons, UHS is obligated to offer a substitution property. If the Trust does not accept the substitution property offered, UHS is obligated to purchase the leased facility back from the Trust at a price equal to the greater of its then fair market value or the original purchase price paid by the Trust. As noted below, transactions with UHS must be approved by a majority of the Trustees who are unaffiliated with UHS (the "Independent Trustees"). The purchase options and rights of first refusal granted to the respective lessees to purchase or lease the respective leased facilities, after the expiration of the lease term, may adversely affect the Trust's ability to sell or lease a facility, and may present a 3 potential conflict of interest between the Trust and UHS since the price and terms offered by a third-party are likely to be dependent, in part, upon the financial performance of the facility during the final years of the lease term. Advisory Agreement. UHS of Delaware, Inc. (the "Advisor"), a wholly-owned subsidiary of UHS, serves as Advisor to the Trust under an Advisory Agreement dated December 24, 1986 between the Advisor and the Trust (the "Advisory Agreement"). Under the Advisory Agreement, the Advisor is obligated to present an investment program to the Trust, to use its best efforts to obtain investments suitable for such program (although it is not obligated to present any particular investment opportunity to the Trust), to provide administrative services to the Trust and to conduct the Trust's day-to-day affairs. In performing its services under the Advisory Agreement, the Advisor may utilize independent professional services, including accounting, legal and other services, for which the Advisor is reimbursed directly by the Trust. The Advisory Agreement expires on December 31 of each year; however, it is renewable by the Trust, subject to a determination by the Independent Trustees that the Advisor's performance has been satisfactory. The Advisory Agreement may be terminated for any reason upon sixty days written notice by the Trust or the Advisor. The Advisory Agreement has been renewed for 1999. All transactions with UHS must be approved by the Independent Trustees. The Advisory Agreement provides that the Advisor is entitled to receive an annual advisory fee equal to .60% of the average invested real estate assets of the Trust, as derived from its consolidated balance sheet from time to time. In addition, the Advisor is entitled to an annual incentive fee equal to 20% of the amount by which cash available for distribution to shareholders for each year, as defined in the Advisory Agreement, exceeds 15% of the Trust's equity as shown on its balance sheet, determined in accordance with generally accepted accounting principles without reduction for return of capital dividends. No incentive fees were paid during 1998, 1997 and 1996. The advisory fee is payable quarterly, subject to adjustment at year end based upon audited financial statements of the Trust. Share Purchase Option. UHS has the option to purchase shares of beneficial interest in the Trust at fair market value to maintain a 5% interest in the Trust. As of December 31, 1998, UHS owned 8% of the outstanding shares of beneficial interest. Competition The Trust believes that it is one of twelve publicly traded real estate investment trusts (REITs) currently investing primarily in income-producing real estate with an emphasis on healthcare related facilities. The REITs compete with one another in that each is continually seeking attractive investment opportunities in healthcare related facilities. The Trust may also compete with banks and other companies, including UHS, in the acquisition, leasing and financing of healthcare related facilities. In most geographical areas in which the Trust's facilities operate, there are other facilities which provide services comparable to those offered by the Trust's facilities, some of which are owned by governmental agencies and supported by tax revenues, and others of which are owned by nonprofit corporations and may be supported to a large extent by endowments and charitable contributions. Such support is not available to the Trust's facilities. In addition, certain hospitals which are located in the areas served by the Trust's facilities are special service hospitals providing medical, surgical and behavioral health services that are not available at the Trust's hospitals or other general hospitals. The competitive position of a hospital is to a large degree dependent upon the number and quality of staff physicians. Although a physician may at any time terminate his or her affiliation with a hospital, the Trust's hospitals seek to retain doctors of varied specializations on its hospital staffs and to attract other 4 qualified doctors by improving facilities and maintaining high ethical and professional standards. The Trust's hospital facilities continue to experience a shift in payor mix resulting in an increase in revenues attributable to managed care payors and unfavorable general industry trends which include pressures to control healthcare costs. Providers participating in managed care programs agree to provide services to patients for a discount from established rates which generally results in pricing concessions by the providers and lower margins. Additionally, managed care companies generally encourage alternatives to inpatient treatment settings and reduce utilization of inpatient services. In response to increased pressure on revenues, the Trust's hospital facilities continue to implement cost control programs including more efficient staffing standards and re-engineering of services. Pressure on operating margins is expected to continue due to, among other things, the changes in Medicare payments mandated by the Balanced Budget Act of 1997 which became effective October 1, 1997 and the industry-wide trend towards managed care which limits the ability of the Trust's hospital facilities to increase their prices. Outpatient treatment and diagnostic facilities, outpatient surgical centers, and freestanding ambulatory surgical centers also impact the healthcare marketplace. Many of the Trust's facilities continue to experience an increase in outpatient revenues which is primarily the result of advances in medical technologies and pharmaceutical improvements, which allow more services to be provided on an outpatient basis, and increased pressure from Medicare, Medicaid, health maintenance organizations ("HMOs"), preferred provider organizations ("PPOs"), and insurers to reduce hospital stays and provide services, where possible, on a less expensive outpatient basis. The hospital industry in the United States, as well as the Trust's hospital facilities, continue to have significant unused capacity which has created substantial competition for patients. Inpatient utilization continues to be negatively affected by payor-required, pre-admission authorization and by payor pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. The Trust expects its hospital facilities to continue to experience increased competition, admission constraints and payor pressures. The Trust anticipates investing in additional healthcare related facilities and leasing the facilities to qualified operators, perhaps including UHS and subsidiaries of UHS. Regulation The Medicare program reimburses the operators of the Trust's hospitals primarily based on established rates by a diagnosis related group for acute care hospitals and by cost based formula for behavioral health facilities. Historically, rates paid under Medicare's prospective payment system ("PPS") for inpatient services have increased, however, these increases have been less than cost increases. The Balanced Budget Act calls for the government to trim the growth of federal spending on Medicare by $115 billion and on Medicaid by $13 billion over the next five years. The act also calls for the reductions in the future rate of increases to payments made to hospitals and reduces the amount of reimbursement for outpatient services, bad debt expense and capital costs. It is likely that future budgets will contain further reductions in the rate of increase of Medicare and Medicaid spending, as evidence by the Clinton Administration's proposed fiscal year 2000 budget which includes a proposal to freeze Medicare hospital payment rates. Outpatient reimbursement for Medicare patients is scheduled to convert to a PPS during the second quarter of 2000. Since final provisions of the outpatient Medicare PPS are not yet available, operators of the Trust's hospitals can not completely estimate the resulting impact on their future results of operations. While the Trust is unable to predict whether this most recent proposal, or any other future health reform legislation, will ultimately be enacted at the federal 5 or state level, the Trust expects continuing pressure to limit expenditures by governmental healthcare programs. Further changes in the Medicare or Medicaid programs and other proposals to limit healthcare spending could have a material adverse impact on the operating results of the Trust's facilities and the healthcare industry. In addition to the Medicare and Medicaid programs, other payors continue to actively negotiate the amounts they will pay for services performed. In general, the operators of the Trust's facilities expect to continue to experience an increase in business from managed care programs, including HMOs and PPOs. The consequent growth in managed care networks and the resulting impact of these networks on the operating results of the Trust's facilities vary among the markets in which the Trust's facilities operate. 6 Executive Officers of the Registrant The executive officers of the Trust are as follows: Name Age Position Alan B. Miller 61 Chairman of the Board and Chief Executive Officer Kirk E. Gorman 48 President, Chief Financial Officer, Secretary and Trustee Charles F. Boyle 39 Vice President and Controller Cheryl K. Ramagano 36 Vice President and Treasurer Timothy J. Fowler 43 Vice President, Acquisition and Development Mr. Alan B. Miller has been Chairman of the Board and Chief Executive Officer of the Trust since its inception in 1986. He served as President of the Trust until March, 1990. Mr. Miller has been Chairman of the Board, President and Chief Executive Officer of UHS since its inception in 1978. Mr. Miller also serves as a director of CDI Corp., Genesis Health Ventures and Penn Mutual Life Insurance Company. Mr. Kirk E. Gorman has been President and Chief Financial Officer of the Trust since March, 1990 and was elected to the Board of Trustees and Secretary in December, 1994. Mr. Gorman had previously served as Vice President and Chief Financial Officer of the Trust since April, 1987. Mr. Gorman was elected Senior Vice President, Treasurer and Chief Financial Officer of UHS in 1992 and served as its Senior Vice President and Treasurer since 1989. Mr. Charles F. Boyle was elected Vice President and Controller of the Trust in June, 1991. Mr. Boyle was promoted to Assistant Vice President - Corporate Accounting of UHS in 1994 and served as its Director of Corporate Accounting since 1989. Ms. Cheryl K. Ramagano was elected Vice President and Treasurer of the Trust in September, 1992. Ms. Ramagano was promoted to Assistant Treasurer of UHS in 1994 and served as its Director of Finance since 1990. Mr. Timothy J. Fowler was elected Vice President, Acquisition and Development of the Trust upon the commencement of his employment with UHS in October, 1993. Prior thereto, he served as a Vice President of The Chase Manhattan Bank, N.A. since 1986. The Trust's officers are all employees of UHS and as of December 31, 1998, the Trust had no salaried employees and paid no cash compensation. In 1999, the Trustees awarded a $50,000 bonus to Mr. Kirk E. Gorman, President, Chief Financial Officer, Secretary and Trustee of the Trust. UHS agreed to a $50,000 reduction in the 1999 advisory fee paid by the Trust. 7Item 2. PropertiesThe following table shows the Trust's investments in hospital facilities leasedto Universal Health Services, Inc. and other non-related parties. The table onthe next page provides information related to various properties in which theTrust has significant investments, some of which are accounted for by the equitymethod. The capacity in terms of beds (for the hospital facilities) and thefive-year occupancy levels are based on information provided by the lessees. Number of Lease Term available ----------------------------- beds @ Average Occupancy (1) Minimum End of Type of ------------------------------------------ initial RenewalHospital Facility Name and Location facility 12/31/98 1998 1997 1996 1995 1994 rent or renewed term term (years)- ----------------------------------------------------------------------------------------------------------------------------------- Chalmette Medical Centers Virtue Street Pavilion (3) Rehabilitation 45 63% 64% 61% 57% 92% $1,261,000 2004 25 Chalmette Medical Center Acute Care 118 61% 64% 66% 67% 66% 921,000 2003 15 Chalmette, Louisiana (2)Inland Valley Regional Medical Center Acute Care 80 60% 52% 49% 49% 45% 1,857,000 2006 30 Wildomar, California (3)McAllen Medical Center Acute Care 472 69% 76% 88% 87% 89% 5,485,000 2001 30 McAllen, Texas (3)Wellington Regional Medical Center Acute Care 120 37% 36% 36% 30% 32% 2,495,000 2006 30 West Palm Beach, Florida (3)The BridgeWay Behavioral Health 70 79% 68% 62% 65% 61% 683,000 2004 25 North Little Rock, Arkansas (3)Meridell Achievement Center Behavioral Health 114 53% 47% 45% 65% 47% 1,071,000 2000 20 Austin, TexasTri-State Regional Rehabilitation Hospital Rehabilitation 80 82% 74% 59% 59% 61% 1,167,000 2004 20 Evansville, Indiana (4)Vencor Hospital Sub-Acute Care 75 42% 50% 45% 38% 38% 1,065,000 2001 25 Chicago, Illinois (5) 8Item 2. Properties (continued) Lease Term ----------------------------------- Type of Average Occupancy (1) Minimum End of initial Renewal ------------------------------- termFacility Name and Location facility 1998 1997 1996 1995 1994 rent or renewed term (years)- ----------------------------------------------------------------------------------------------------------------------------------- Fresno - Herndon Medical Plaza Medical 100% 100% 100% 100% - $740,000 1999 -2003 various Fresno, California (6) Office BuildingKelsey-Seybold Clinic at King's Crossing Medical 100% 100% 100% 100% - 264,000 2005 10Professional Center at King's Crossing Office Buildings 100% 100% 93% 100% - 299,000 2000 -2005 various Kingwood, Texas (7)The Southern Crescent Center Medical 100% 100% 89% - - 795,000 1999 -2006 various Riverdale, Georgia (8) Office BuildingThe Cypresswood Professional Center Medical 100% 96% - - - 524,000 2002 -2007 various Spring, Texas (9) Office Building Desert Samaritan Medical Buildings Medical 99% 97% 97% - - 4,147,000 1998-2008 various Phoenix, Arizona (10) Office BuildingsDesert Springs Medical Plaza Medical 100% - - - - 1,633,000 1999-2002 various Las Vegas, Nevada (11) Office BuildingEdwards Medical Plaza Medical 87% - - - - 2,212,000 1999-2005 various Phoenix, Arizona (12) Office Building 9 (1) Average occupancy rate for the hospital facilities is based on the average number of available beds occupied during the five years ended December 31, 1998. Average occupancy rate for the multi-tenant medical office buildings is based on the occupied square footage of each building. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for effects of various occupancy levels at the Trust's hospital facilities. Average available beds is the number of beds which are actually in service at any given time for immediate patient use with the necessary equipment and staff available for patient care. A hospital may have appropriate licenses for more beds than are in service for a number of reasons, including lack of demand, incomplete construction, and anticipation of future needs. (2) The operations of The Virtue Street Pavilion and Chalmette Medical Center, two facilities which are separated by approximately one mile, were combined at the end of 1989. Each facility is leased pursuant to a separate lease. The Chalmette Medical Center facility is a 118-bed medical/surgical facility. The Virtue Street Pavilion is a 73-bed facility made up of a physical rehabilitation unit, skilled nursing and inpatient behavioral health services. In December of 1994, the operator of the Virtue Street Pavilion entered into a three year sub-lease agreement with Lifecare Hospitals of New Orleans, LLC, for a portion of the facility. Annual rental is $1.1 million under the provisions of this agreement. The sub-lease, which expires in December, 2000, contains one three year extension at the lessee's option. No assurance can be given as to the effect, if any, the consolidation of the two facilities as mentioned above, had on the underlying value of the Virtue Street Pavilion and Chalmette Medical Center. Rental commitments and the guarantee by UHS under the existing leases continue for the remainder of the respective terms of the leases. (3) During 1998, wholly-owned subsidiaries of UHS exercised five-year renewal options on four hospitals owned by the Trust which were scheduled to expire in 1999 through 2001 (Virtue Street Pavilion, The Bridgeway, Inland Valley Regional Medical Center and Wellington Medical Center ). The leases on these facilities were renewed at the same lease rates and terms as the initial leases. As part of the renewal agreement, the Trust also agreed to grant additional fixed rate renewal options to a wholly-owned subsidiary of UHS commencing in 2022 on the real property of McAllen Medical Center. (4) The Trust purchased this hospital during 1989 for approximately $7.5 million. During 1993, the Trust purchased for approximately $1.1 million, a 20 bed addition which was added to the facility. The Trust entered into an agreement with the operator, an unaffiliated third-party, to lease the facility for an initial fixed term of 10 years, with the operator having the option to extend the lease for five 5-year renewal terms. Subsequent to December 31, 1998, the lease on this facility was amended and renewed for a five-year term commencing on June 1, 1999 and ending on May 31, 2004. Pursuant to the terms of the lease as amended, the minimum rent has been increased and the additional rent provision has been eliminated (5) During December of 1993, UHS, the former lessee and operator of Belmont Community Hospital, sold the operations of the facility to THC-Chicago, Inc., an indirect wholly-owned subsidiary of Community Psychiatric Centers ("CPC"). Concurrently, the Trust purchased certain related real property from UHS for $1 million in cash and a note payable with a carrying value of $1.2 million at December 31, 1998. The note payable has a face value of $1 million and is due on December 31, 2001. The amount of interest payable on this note is contingent upon the financial performance of this leased facility and its estimated fair value at the end of the initial lease term. The Trust has estimated the total amount payable under the terms of this note and has discounted the payments to their net present value using a 6% rate. 10 Included in the Trust's 1998 financial results is approximately $69,000 of interest expense related to this note. In connection with this transaction, UHS's lease with the Trust was terminated and the Trust entered into an eight year lease agreement with THC-Chicago. In 1997, CPC was acquired by Vencor, Inc. who assumed their obligations under the lease and renamed the facility Vencor Hospital-Chicago. The lease is guaranteed by Vencor, Inc. (6) In November of 1994, the Trust purchased the Fresno-Herndon Medical Plaza located in Fresno, California for $6.3 million. The 37,800 square foot medical office building is leased to several tenants, including an outpatient surgery center operated by Columbia/HCA Healthcare Corporation, under the terms of leases with expiration dates ranging from November, 1999 to March, 2003. The Trust has granted the seller the option to repurchase the property in November, 2001 for $7,250,000. (7) In December of 1994, the Trust agreed to provide construction financing for the Professional Center at Kings Crossing, of which $1.1 million was advanced during 1994 and $3.2 million was advanced during 1995. During the fourth quarter of 1995, upon completion and occupancy of the properties, the Trust purchased the single tenant and two multi-tenant medical office buildings for the total construction cost of $4.3 million. The single tenant building consists of 20,000 net square feet and is leased to Kelsey-Seybold, a subsidiary of Caremark International, Inc., for an initial term of 10 years. The two multi-tenant buildings total 27,535 net square feet and are occupied by tenants consisting primarily of medical professionals. The lease is guaranteed by Caremark International, Inc., a subsidiary of Medpartners, Inc. (8) During the second quarter of 1996, the Trust purchased The Southern Crescent Center, a multi-tenant medical office building, for approximately $6 million. The Southern Crescent Center is a 41,400 square foot, multi-tenant medical office building located adjacent to the Southern Regional Medical Center in Riverdale, Georgia. (9) Construction on the Cypresswood Professional Center, located in Houston, Texas, was completed during 1997 for a total cost of $4.4 million. In connection with this investment, the Trust provided five-year financing (which matures in August, 2002) to a limited partnership which owns the real estate assets of this facility. The Trust owns a 77% controlling interest in the partnership. (10) In January 1996, the Trust invested $5 million to acquire a 61% non-controlling interest in a limited liability company that owns three medical office buildings located in Phoenix, Arizona. The three buildings total approximately 194,000 gross square feet and are leased to several tenants. In connection with this investment the limited liability company obtained non-recourse, third-party financing, which has outstanding balance at December 31, 1998 of $17.1 million. (11) Since April 1998, the Trust invested a total of $10.1 million to acquire a 99% non-controlling interest in a limited liability company that owns the Desert Springs Medical Plaza located in Las Vegas, Nevada. The 89,000 square foot medical office building, which is located on the campus of Desert Springs Hospital, is master leased and guaranteed by Quorum Health Group, Inc. In connection with this investment the limited liability company obtained non-recourse, third-party financing, which has an outstanding balance at December 31, 1998 of $5.9 million. (12) In April 1998, the Trust invested $3.8 million to acquire a 95% non-controlling interest in a limited liability company that owns the Edwards Medical Plaza located in Phoenix, Arizona. 11 The 85,000 square foot medical office building, which is leased to multiple tenants, is located on the campus of the Good Samaritan Regional Medical Center. In connection with this investment the limited liability company obtained non-recourse, third-party financing which has an outstanding balance at December 31, 1998 of $7.5 million Item 3. LEGAL PROCEEDINGS Not Applicable. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. No matter was submitted during the fourth quarter of the year ended December 31, 1998 to a vote of security holders. 12 PART II Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Trust's shares of beneficial interest are listed on the New York Stock Exchange. The high and low closing sales prices for the Trust shares of beneficial interest for each quarter in the two years ended December 31, 1998 and 1997 are summarized below: 1998 1997 ------------------------------------ --------------------------------------- High Price Low Price High Price Low Price ----------------- ------------------ -------------------- ------------------ First Quarter $22 1/2 $21 $22 3/8 $19 3/4 Second Quarter $21 3/8 $18 13/16 $20 $18 1/2 Third Quarter $20 1/4 $18 1/16 $21 1/2 $18 15/16 Fourth Quarter $20 1/4 $18 3/8 $21 7/8 $20 1/16 As of January 31, 1999, there were approximately 982 shareholders of record of the Trust's shares of beneficial interest. It is the Trust's intention to declare quarterly dividends to the holders of its shares of beneficial interest so as to comply with applicable sections of the Internal Revenue Code governing real estate investment trusts. Covenants relating to the revolving credit facility limit the Trust's ability to increase dividends in excess of 95% of cash available for distribution unless additional distributions are required to be made so as to comply with applicable sections of the Internal Revenue Code and related regulations governing real estate investment trusts. In each of the past five years, dividends per share were declared as follows: 1998 1997 1996 1995 1994 ---------- ---------- ---------- --------- ---------- First Quarter $ .435 $ .425 $ .420 $ .42 $ .415Second Quarter .435 .425 .425 .42 .415Third Quarter .440 .425 .425 .42 .415Fourth Quarter .445 .430 .425 .42 .420 ---------- ---------- ---------- --------- ---------- $ 1.755 $ 1.705 $ 1.695 $ 1.68 $ 1.665 ========== ========== ========== ========= ========== 12 Item 6. SELECTED FINANCIAL DATA Financial highlights for the Trust for the five years ended December 31, 1998 were as follows: 1998 (1) 1997 (1) 1996 (1) 1995 1994 ----------------------------- ----------------- ----------------- ----------------- ----------------- ----------------- Revenues $23,234,000 $22,764,000 $21,923,000 $20,417,000 $18,826,000 Net income $14,337,000 $13,967,000 $14,158,000 $13,584,000 $14,312,000 Funds from Operations (2) $19,857,000 $18,809,000 $18,174,000 $17,024,000 $17,501,000 Per Share Data: Net income-Basic $1.60 $1.56 $1.58 $1.52 $1.60 Net income-Diluted $1.60 $1.56 $1.58 $1.52 $1.60 Dividends $1.755 $1.705 $1.695 $1.680 $1.665 (1) See "Management's Discussion and Analysis of Financial Condition and Results of Operations." (2) Funds from operations ("FFO") may not be calculated in the same manner for all companies, and accordingly, FFO as presented above may not be comparable to similarly titled measures by other companies. FFO does not represent cash flows from operations as defined by generally accepted accounting principles and should not be considered as an alternative to net income as an indicator of the Trust's operating performance or to cash flows as a measure of liquidity. FFO shown above is calculated as follows: 1998 1997 1996 1995 1994 Net income $14,337,000 $13,967,000 $14,158,000 $13,584,000 $14,312,000Depreciation expense: Consolidated investments 3,809,000 3,740,000 3,554,000 3,315,000 3,127,000 Unconsolidated affiliates 1,587,000 978,000 337,000 -- --Amortization of interest rate cap 124,000 124,000 125,000 125,000 62,000 ----------- ----------- ----------- ----------- ----------- Total $19,857,000 $18,809,000 $18,174,000 $17,024,000 $17,501,000 =========== =========== =========== =========== ===========At End of Period 1998 1997 1996 1995 1994 - --------------------------------------------------------------------------------------------------- Total Assets $169,406,000 $146,755,000 $148,566,000 $132,770,000 $128,907,000Debt $ 66,016,000 $ 42,347,000 $ 43,082,000 $ 26,396,000 $ 21,283,000 14 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward Looking Statements The matters discussed in this report, as well as the news releases issued from time to time by the Trust, include certain statements containing the words "believes", "anticipates", "intends", "expects", and words of similar import, which constitute "forward-looking statements" within the meaning of Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Trust's or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, the following: a substantial portion of the Trust's revenues are dependent on one operator, Universal Health Services, Inc., ("UHS"); a substantial portion of the Trust's leases are involved in the healthcare industry which is undergoing substantial changes and is subject to possible changes in the levels and terms of reimbursement from third-party payors and government reimbursement programs, including Medicare and Medicaid; the Trust's ability to finance its growth on favorable terms; the impact of Year 2000 issues; liability and other claims asserted against the Trust or operators of the Trust's facilities, and other factors referenced herein. Additionally, the operators of the Trust's facilities, including UHS, are confronted with other issues such as: industry capacity; demographic changes; existing laws and government regulations and changes in or failure to comply with laws and governmental regulations; the ability to enter into managed care provider agreements on acceptable terms; competition; the loss of significant customers; technological and pharmaceutical improvements that increase the cost of providing, or reduce the demand for healthcare; and the ability to attract and retain qualified personnel, including physicians. Management of the Trust is unable to predict the effect, if any, these factors will have on the operating results of its lessees, including the facilities leased to subsidiaries of UHS. Given these uncertainties, prospective investors are cautioned not to place undue reliance on such forward-looking statements. The Trust disclaims any obligation to update any such factors or to publicly announce the result of any revisions to any of the forward-looking statements contained herein to reflect future events or developments. Liquidity and Capital Resources General The Trust commenced operations on December 24, 1986. As of December 31, 1998, the Trust had investments in thirty-one facilities located in fourteen states. It is the Trust's intention to declare quarterly dividends to the holders of its shares of beneficial interest so as to comply with applicable sections of the Internal Revenue Code governing real estate investment trusts. Convenants relating to the revolving credit facility limit the Trust's ability to increase dividends in excess of 95% of cash available for distribution unless additional distributions are required to be made to comply with applicable sections of the Internal Revenue Code and related regulations governing real estate investment trusts. During 1998, dividends of $1.755 per share, or $15,716,000 in the aggregate, were declared and paid. 15 Net cash generated by operating activities was $18.7 million in 1998, $17.7 million in 1997 and $18.0 million in 1996. The $1 million net increase in 1998 as compared to 1997 was due primarily to: (i) a $500,000 increase in net income plus the addback of the non-cash charges (depreciation, amortization, and amortization of interest rate cap expense); (ii) a $100,00 favorable change in rent receivable, and; (iii) a $400,000 favorable change in tenant escrows, deposits and prepaid rents. The $300,000 net decrease in 1997 as compared to 1996 was due primarily to a $100,000 decrease in net income plus the addback of the non-cash charges (as defined above) and $200,000 of unfavorable changes in other net working capital accounts. During 1998, the $18.7 million of cash flows generated from operations, the $23.6 million of additional borrowings, the $900,000 of cash distributions received in excess of income from the Trust's investments in LLCs and the $600,000 reduction in cash were used primarily to: (i) pay dividends ($15.7 million); (ii) investments in and advances to five limited liability companies ($27.9 million, see Note 3), and; (iii) purchase real property and additions to land and buildings ($200,000). Included in the $27.9 million invested in/advanced to limited liability companies was $10.0 million of short-term loans advanced to three separate LLCs in which the Trust has ownership interests ranging from 48% to 95%. These loans, which are earning interest at variable rates depending upon the length of time the loan is outstanding, earned interest at an annual average rate of 9% for 1998. The loans are expected to be fully repaid to the Trust during 1999 once the LLCs secure long-term, third-party financing. During 1997, the $17.7 million of cash flows generated from operations, the $6.8 million of cash received for repayments under a mortgage and a construction note receivable (net of $3.4 million of advances in 1997) and the $600,000 of cash distributions received in excess of income from the Trust's investments in LLCs were used primarily to: (i) pay dividends ($15.3 million); (ii) purchase real property and additions to land and buildings ($4.2 million); (iii) purchase equity interests in two limited liability companies ($3.7 million, see Note 3), and; (iv) repay debt ($800,000). As of December 31, 1997, the Trust had a $1 million short-term cash investment which was used to repay debt in the beginning of January, 1998. During 1996, the $18.0 million of cash flows generated from operations and the $16.6 million of additional borrowings were used primarily to: (i) pay dividends ($15.2 million); (ii) purchase additional real property ($10.2 million, see Note 3); (iii) purchase equity interest in various limited liability companies ($7.6 million, see Note 3), and; (iv) begin construction on two new medical office buildings which will be owned by limited liability companies and limited partnerships in which the Trust will own equity interests ($1.6 million, see Note 3). During 1998, the Trust replaced its $70 million revolving credit agreement with a new $80 million unsecured, non-amortizing revolving credit agreement (the "Agreement"), which is scheduled to expire in June, 2003. During the term of the Agreement, the Trust has the option to request an increase in the borrowing capacity to $100 million. The Agreement provides for interest at the Trust's option, at the certificate of deposit rate plus 5/8% to 1 1/8%, Eurodollar rate plus 1/2% to 1 1/8% or the prime rate. A fee of .175% to .375% is required on the unused portion of this commitment. The margins over the certificate of deposit rate, Eurodollar rate and the commitment fee are based upon the Trust's debt to total capital ratio as defined by the Agreement. At December 31, 1998, the applicable margin over the certificate of deposit and Eurodollar rates were 7/8% and 5/8%, respectively, and the commitment fee was .20%. There are no compensating balance requirements. The Agreement contains a provision whereby the commitments will be reduced by 50% of the proceeds generated from any new equity offering. At December 31, 1998, the Trust had approximately $12 million of available borrowing capacity. 16 Covenants relating to the revolving credit facility require the maintenance of a minimum tangible net worth and specified financial ratios, limit the Trust's ability to incur additional debt, limit the aggregate amount of mortgage receivables and limit the Trust's ability to increase dividends in excess of 95% of cash available for distribution, unless additional distributions are required to comply with the applicable section of the Internal Revenue Code and related regulations governing real estate investment trusts. The Trust has entered into interest rate swap agreements and an interest rate cap agreement which are designed to reduce the impact of changes in interest rates on its floating rate revolving credit notes. The Trust has three outstanding swap agreements for notional principal amounts of $5 million, $4 million and $1,580,000 which mature in May, 1999, July, 2002 and May, 2001, respectively. These swap agreements effectively fix the interest rate on $10,580,000 of variable rate debt at 7.56% including the revolver spread of .625%. The interest rate cap, for which the Trust paid $622,750, (unamortized premium of $62,000 at December 31, 1998) matures in June, 1999 and fixes the maximum rate on $15 million of variable rate revolving credit notes at 7.625% including the revolver spread of .625%. The interest rate swap and cap agreements were entered into in anticipation of certain borrowing transactions made by the Trust during 1995, 1996 and 1997. The effective rate on the Trust's revolving credit notes including commitment fees and interest rate swap expense was 6.7%, 6.9% and 6.8% during 1998, 1997 and 1996, respectively. Additional interest expense recorded as a result of the Trust's hedging activity, which is included in the effective interest rates shown above, was $136,000, $118,000 and $130,000 in 1998, 1997 and 1996, respectively. The Trust is exposed to credit loss in the event of non-performance by the counterparties to the interest rate swap and cap agreements. These counterparties are major financial institutions and the Trust does not anticipate non-performance by the counterparties which are rated A or better by Moody's Investors Service. Termination of the interest rate swaps at December 31, 1998 would have resulted in payments to the counterparties of approximately $322,000 and termination of the interest rate cap would have had no impact on the Trust. The fair value of the interest rate swap and cap agreements at December 31, 1998 reflects the estimated amounts that the Trust would pay or receive to terminate the contracts and are based on quotes from the counterparties. Results of Operations Total revenues increased 2% or $470,000 to $23.2 million in 1998 as compared to 1997 and 4% or $841,000 to $22.8 million in 1997 as compared to 1996. The $470,000 increase during 1998 over 1997 was due primarily to a $788,000 increase in base rentals from non-related parties (due primarily to the completion of The Cypresswood Professional Center during the third quarter of 1997), and a $122,000 increase in bonus rental income from UHS facilities. These favorable changes were partially offset by a $473,000 decrease in interest income due to a mortgage loan receivable which was fully repaid in June, 1997 and a construction loan receivable which was repaid in December, 1997. The $841,000 increase during 1997 over 1996 was primarily attributable to an increase in base rentals from non-related parties due to the various acquisitions made by the Trust during the second quarter of 1996 and the third quarter of 1997 (see Note 3). The average occupancy rate of a hospital is affected by a number of factors, including the number of physicians using the hospital, changes in the number of beds, the composition and size of the population of the community in which the hospital is located, general and local economic conditions, variations in local medical and surgical practices and the degree of outpatient use of the hospital services. Current industry trends in utilization and occupancy have been significantly affected by changes in reimbursement policies of third-party payors. A continuation of such 17 industry trends could have a material adverse impact upon the future operating performance of the Trust's hospital facilities. The Trust's hospital facilities have experienced growth in outpatient utilization over the past several years. The increase in outpatient services is primarily the result of advances in medical technologies and pharmaceutical improvements, which allow more services to be provided on an outpatient basis, and increased pressure from Medicare, Medicaid, managed care companies and other insurers to reduce hospital stays and provide services where possible, on a less expensive outpatient basis. The hospital industry in the United States as well as the Trust's hospital facilities continue to have significant unused capacity which has created substantial competition for patients. Inpatient utilization continues to be negatively affected by payor-required, pre-admission authorization and by payor pressure to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. The Trust expects the increased competition, admission constraints and payor pressures to continue. The ability of the Trust's hospital facilities to maintain their historical rate of net revenue growth and operating margins is dependent upon their ability to successfully respond to these trends as well as reductions in spending on governmental healthcare programs. A significant portion of the revenues generated at the Trust's hospital facilities are derived from fixed payment services, including Medicare and Medicaid. The Medicare program reimburses the Trust's hospital facilities primarily based on established rates by a diagnosis related group for acute care hospitals and by a cost based formula for behavioral health facilities. Historically, rates paid under Medicare's prospective payment system ("PPS") for inpatient services have increased, however, these increases have been less than cost increases. The Balanced Budget Act calls for the government to trim the growth of federal spending on Medicare by $115 billion and on Medicaid by $13 billion over the next five years. The act also calls for the reductions in the future rate of increases to payments made to hospitals and reduces the amount of reimbursement for outpatient services, bad debt expense and capital costs. It is likely that future budgets will contain further reductions in the rate of increase of Medicare and Medicaid spending, as evidence by the Clinton Administration's proposed fiscal year 2000 budget which includes a proposal to freeze Medicare hospital payment rates. Outpatient reimbursement for Medicare patients is scheduled to convert to a PPS during the second quarter of 2000. Since final provisions of the outpatient Medicare PPS are not yet available, operators of the Trust's hospitals can not completely estimate the resulting impact on their future results of operations. While the Trust is unable to predict whether this most recent proposal, or any other future health reform legislation, will ultimately be enacted at the federal or state level, the Trust expects continuing pressure to limit expenditures by governmental healthcare programs. Further changes in the Medicare or Medicaid programs and other proposals to limit healthcare spending could have a material adverse impact on the operating results of the Trust's facilities and the healthcare industry. In general, the operators of the Trust's hospital facilities expect to continue to experience an increase in business from managed care programs, including HMOs and PPOs. The consequent growth in managed care networks and the resulting impact of these networks on the operating results of the Trust's facilities vary among the markets in which the Trust's facilities operate. Management of the Trust is unable to predict the rate of growth of the net revenues of its facilities and the resulting impact on bonus revenues, which are computed as a percentage of each facility's net revenues in excess of base year amounts or CPI increases in excess of base year amounts. Net revenues of the Trust's facilities are dependent upon developments in medical technologies and physician practice patterns, both of which are beyond the control of management of the facilities. Interest expense increased $547,000 or 19% in 1998 as compared to 1997 and $378,000 or 15% in 1997 as compared to 1996 due primarily to the additional borrowings used to finance the 1998, 18 1997 and 1996 investments described in Note 3. Depreciation and amortization expense increased $104,000 or 3% in 1998 as compared to 1997 and $139,000 or 4% in 1997 as compared to 1996 due primarily to the depreciation expense related to the 1997 and 1996 acquisitions described in Note 3. Other operating expenses increased $479,000 or 34% in 1998 as compared to 1997 due to the operating expenses on the Cypresswood Professional Center on which construction was completed during the third quarter of 1997 and an increase in various other operating expenses. Other operating expenses increased $276,000 or 24% in 1997 as compared to 1996 due primarily to the expenses related to the medical office buildings acquired by the Trust during the second quarter of 1996 and the third quarter of 1997 and an increase in various other operating expenses. The expenses related to the medical office buildings, in which the Trust has a controlling ownership interest, totaled $1.0 million in 1998, $770,000 in 1997 and $551,000 in 1996. The majority of these expenses are passed on directly to the tenants and are included as revenues in the Trust's statements of income. Net income for 1998 was $14.3 million or $1.60 per basic and diluted share compared to $14.0 million or $1.56 per basic and diluted share in 1997 and $14.2 million or $1.58 per basic and diluted share in 1996. Funds from operations ("FFO"), which is the sum of net income plus depreciation expense for consolidated investments and unconsolidated investments and amortization of interest rate cap expense, totaled $19.9 million in 1998, $18.8 million in 1997 and $18.2 million in 1996. FFO may not be calculated in the same manner for all companies, and accordingly, may not be comparable to similarly titled measures by other companies. FFO does not represent cash flows from operations as defined by generally accepted accounting principles and should not be considered as an alternative to net income as an indicator of the Trust's operating performance or to cash flows as a measure of liquidity. General During the third quarter of 1998, wholly-owned subsidiaries of UHS exercised five-year renewal options on four hospitals owned by the Trust which were scheduled to expire in 1999 through 2001 (Virtue Street Pavilion, The Bridgeway, Inland Valley Regional Medical Center and Wellington Regional Medical Center). The leases on these facilities were renewed at the same lease rates and terms as the initial leases and these renewals remove the majority of the previously disclosed uncertainty regarding the lease renewals with subsidiaries of UHS. As part of the renewal agreement, the Trust also agreed to grant additional fixed rate renewal options to a wholly-owned subsidiary of UHS commencing in 2022 on the real property of McAllen Medical Center. Management of the Trust can not predict whether the leases with subsidiaries of UHS, which have renewal options at existing lease rates, or any of the Trust's other leases, will be renewed at the end of their initial term or first five-year renewal term. 19 Year 2000 Issue The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. Computer programs, certain building infrastructure components (including elevators, alarm systems and certain HVAC systems) and certain computer aided medical equipment that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in system failures or miscalculations causing disruption of operations or medical equipment malfunctions that could affect patient diagnosis and treatment. Management of the Trust recognizes the need to evaluate the impact on its operations of the change to calendar year 2000 and does not expect the total cost of required building related modifications to have a material impact on its results of operations. Approximately 72% of the Trust's total revenues for the three year period ended December 31, 1998, were earned under the terms of the leases with wholly-owned subsidiaries of UHS. UHS has undertaken steps to inventory and assess applications and equipment at risk to be affected by Year 2000 issues and to convert, remediate or replace such applications and equipment. UHS has completed its assessment of its major financial and clinical software and believes that such software is substantially Year 2000 compliant. As to certain peripheral software, UHS has scheduled upgrades to be completed by June, 1999. For its biomedical equipment, UHS expects to complete the assessment phase of its Year 2000 analysis by early in the second quarter of 1999. UHS believes that Year 2000 related remediation costs incurred through December 31, 1998 have not had a material impact on its results of operations. However, UHS is not able to reasonably estimate the total capital costs to be incurred for equipment replacement since the equipment analysis phase has not yet been completed. Some replacement or upgrade of systems and equipment would take place in the normal course of business. Several systems, key to UHS's operations, have been scheduled to be replaced through vendor supplied systems before Year 2000. The costs of repairing existing systems is expensed as incurred. UHS has allocated a portion of its 1999 capital budget as Year 2000 contingency funds and expects that all of the capital costs can be accommodated within that budget. UHS presently believes that with modifications to existing software and conversions to new software, the Year 2000 issue will not pose material operational problems for its computer systems. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 issue could have a material impact on the operations of UHS and UHS's ability to meet its obligations under the terms of its leases with the Trust. The majority of the software used by UHS is purchased from third parties. UHS is relying on software (including UHS's major outsourcing vendor which provides the financial and clinical applications for the majority of UHS's acute care facilities), hardware and other equipment vendors to verify Year 2000 compliance of their products. UHS also depends on: fiscal intermediaries which process claims and make payments for the Medicare program; health maintenance organizations, insurance companies and other private payors; vendors of medical supplies and pharmaceuticals used in patient care; and, providers of utilities such as electricity, water, natural gas and telephone services. As part of its Year 2000 strategy, UHS intends to seek assurances from these parties that their services and products will not be interrupted or malfunction due to the Year 2000 problem. Failure of third parties to resolve their Year 2000 issues could have a material adverse effect on UHS's results of operations and its ability to provide health care services. 20 Each of UHS's hospitals has a disaster plan which will be reviewed as part of UHS's Year 2000 contingency planning process. However, no assurance can be given that UHS will be able to develop contingency plans which will enable each of its facilities to continue to operate in all circumstances. This Year 2000 assessment is based on information currently available to UHS and the Trust and UHS and the Trust will revise its assessment at it implements its Year 2000 strategy. UHS can provide no assurance that applications and equipment UHS believes to be Year 2000 compliant will not experience difficulties or that UHS will not experience difficulties obtaining resources needed to make modifications to or replace its affected systems and equipment. Failure by UHS or third parties on which it relies to resolve Year 2000 issues could have a material adverse effect on its results of operations, its ability to provide health care services and on UHS's ability to meet its obligations under the terms of its leases with the Trust. Consequently, the Trust can give no assurances that issues related to Year 2000 will not have a material adverse effect on it's financial condition or results of operations. With respect to the Trust's non-related properties, an assessment was conducted by the Trust which covered the compliance efforts of the tenants and based upon the responses received, these tenants do not expect Year 2000 related issues to have a material impact on their operations. Management of the Trust will continue to monitor the Year 2000 compliance efforts of its non-related tenants as well as the effects of potential non-compliance. The Trust will develop contingency plans if, and to the extent, deemed necessary. However, based upon current information and barring developments, the Trust does not anticipate developing any substantive contingency plans with respect to Year 2000 issues. In addition, the Trust has no plans to seek independent verification or review of its assessments. The Trust believes that its expenditures for assessing and correcting Year 2000 issues have not been material. In addition, the Trust is not aware of any issues that will require material expenditures by the Trust or tenants of the Trust's facilities in the future. Based upon current information, the Trust believes that the risk posed by the foreseeable Year 2000 related problems with its internal systems, (including both information and non-information systems) is minimal. Year 2000 related problems at certain third-party payors, service providers and non-related tenants is greater, however, based upon current information, the Trust does not believe such problems will have a material effect on its operations. While the Trust believes that it will be Year 2000 compliant by December 31, 1999, there can be no assurance that the Trust or tenants of the Trust's properties will be successful in identifying and assessing all compliance issues, or that the efforts of the Trust or tenants of the Trust' properties to remedy all Year 2000 compliance issues will be effective such that they will not have a material adverse effect on the Trust's business or results of operations. Market Risks Associated with Financial Instruments The Trust's interest expense is sensitive to changes in the general level of domestic interest rates. To mitigate the impact of fluctuations in domestic interest rates, a portion of the Trust's debt is fixed rate accomplished by entering into interest rate swap agreements. The interest rate swap agreements are contracts that require the Trust to pay a fixed and receive a floating interest rate over the life of the agreements. The floating-rates are based on LIBOR and the fixed-rates are determined upon consummation of the swap agreements. The interest rate swap agreements do not constitute positions independent of the underlying exposures. The Trust does not hold or 21 issue derivative instruments for trading purposes and is not a party to any instruments with leverage features. The Trust is exposed to credit losses in the event of non-performance by the counterparties to its financial instruments. The counterparties are creditworthy financial institutions, rated A or better by Moody's Investor Services and the Trust anticipates that the counterparties will be able to fully satisfy their obligations under the contracts. For the years ended December 31, 1998, 1997 and 1996, the Trust received a weighted average rate of 5.24%, 5.79% and 5.60%, respectively, and paid a weighted average rate on its interest rate swap agreements of 6.94%, 6.94% and 6.80%, respectively. The table below presents information about the Trust's derivative financial instruments and other financial instruments that are sensitive to changes in interest rates, including interest rate swaps as of December 31, 1998. For debt obligations, the table presents principal cash flows and related weighted-average interest rates by contractual maturity dates. For interest rate swap agreements, the table presents notional amounts by expected maturity date and weighted average interest rates based on rates in effect at December 31, 1998. Maturity Date, Fiscal Year Ending December 31 There- (Dollars in thousands) 1999 2000 2001 2002 2003 after Total ---- ---- ---- ---- ---- ----- ----- Long-term debt: Fixed rate $1,216 $1,216 Average interest rates 6.0% Variable rate long-term debt 64,800 64,800 Interest rate swaps: Pay fixed/receive variable notional amounts 5,000 1,580 4,000 10,580 Average pay rate 7.245% 6.80% 6.6025% Average receive rate 3 month 3 month 6 month LIBOR LIBOR LIBOR Interest rate caps 15,000 15,000 Cap rate 7.0% Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Trust's Balance Sheets and its Statements of Income, Changes in Shareholders' Equity and Cash Flows, together with the report of Arthur Andersen LLP, independent public accountants, are included elsewhere herein. Reference is made to the "Index to Financial Statements and Schedules." Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 22 PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There is hereby incorporated by reference the information to appear under the caption "Election of Trustees" in the Trust's definitive Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1998. See also "Executive Officers of the Registrant" appearing in Part I hereof. Item 11. EXECUTIVE COMPENSATION There is hereby incorporated by reference the information under the caption "Executive Compensation" and "Compensation Pursuant to Plans" in the Trust's definitive Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1998. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is hereby incorporated by reference the information under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Trust's definitive Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1998. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is hereby incorporated by reference the information under the caption "Transactions With Management and Others" in the Trust's definitive Proxy Statement to be filed with the Securities and Exchange Commission within 120 days after December 31, 1998. 23 PART IV Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedules: 1) Report of Independent Public Accountants 2) Financial Statements Consolidated Balance Sheets - December 31, 1998 and December 31, 1997 Consolidated Statements of Income - Years Ended December 31, 1998, 1997 and 1996 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1998, 1997 and 1996 Consolidated Statements of Cash Flows - Years Ended December 31, 1998, 1997 and 1996 Notes to Consolidated Financial Statements - December 31, 1998 (3) Schedules Schedule II - Valuation and Qualifying Accounts - Years Ended December 31, 1998, 1997 and 1996 Schedule III - Real Estate and Accumulated Depreciation - December 31, 1998 Notes to Schedule III - December 31, 1998 (b) Reports on Form 8-K: No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1998 (c) Exhibits: 3.1 Declaration of Trust, dated as of August 1986, previously filed as Exhibit 3.1 Amendment No. 3 of the Registration Statement on Form S-11 and Form S-2 of Universal Health Services, Inc. and the Trust (Registration No. 33-7872), is incorporated herein by reference. 3.2 Amendment to Declaration of Trust, dated as of June 23, 1993, previously filed as Exhibit 3.2 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1993, is incorporated herein by reference. 3.3 Amended and restated bylaws, filed as Exhibit 10.1 to the Trust's Form 10-Q for the quarter ended March 31, 1998, is incorporated herein by reference. 10.1 Advisory Agreement, dated as of December 24, 1986, between UHS of Delaware, Inc. and The Trust, previously filed as Exhibit 10.2 to the Trust's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.2 Agreement effective January 1, 1999, to renew Advisory Agreement dated as of December 24, 1986 between Universal Health Realty Income Trust and UHS of Delaware, Inc. 24 10.3 Contract of Acquisition, dated as of August 1986, between the Trust and certain subsidiaries of Universal Health Services, Inc., previously filed as Exhibit 10.2 to Amendment No. 3 of the Registration Statement on Form S-11 and S-2 of Universal Health Services, Inc. and the Trust (Registration No. 33-7872), is incorporated herein by reference. 10.4 Form of Leases, including Form of Master Lease Document Leases, between certain subsidiaries of Universal Health Services, Inc. and the Trust, previously filed as Exhibit 10.3 to Amendment No. 3 of the Registration Statement on Form S-11 and Form S-2 of Universal Health Services, Inc. and the Trust (Registration No. 33-7872), is incorporated herein by reference. 10.5 Share Option Agreement, dated as of December 24, 1986, between the Trust and Universal Health Services, Inc., previously filed as Exhibit 10.4 to the Trust's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.6 Corporate Guaranty of Obligations of Subsidiaries Pursuant to Leases and Contract of Acquisition, dated December 1986, issued by Universal Health Services, Inc. in favor of the Trust, previously filed as Exhibit 10.5 to the Trust's Current Report on Form 8-K dated December 24, 1986, is incorporated herein by reference. 10.7 Contract of Acquisition dated August 31, 1988 between the Trust, Rehab Systems Company, Inc. and Tri-State Regional Rehabilitation Hospital, Inc., previously filed as Exhibit 10.2 to the Trust's September 30, 1988 Form 10-Q, is incorporated herein by reference. 10.8 Key Employees' Restricted Share Purchase Plan approved by the Trustees on December 1, 1988 which authorized the issuance of up to 50,000 common shares, previously filed as Exhibit 10.11 to the Trust's Annual Report on form 10-K for the year ended December 31, 1988, is incorporated herein by reference. 10.9 Share Compensation Plan for Outside Trustees, previously filed as Exhibit 10.12 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.10 1988 Non-Statutory Stock Option Plan, as amended, previously filed as Exhibit 10.13 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. 10.11 Lease dated December 22, 1993, between Universal Health Realty Income Trust and THC-Chicago, Inc. as lessee, previously filed as Exhibit 10.14 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1993, is incorporated herein by reference. 10.12 Mortgage Modification, Consolidation and Extension Agreement and Consolidated Note dated December 28, 1993 in the amount of $6,500,000 from Crouse Irving Memorial Properties, Inc. to Universal Health Realty Income Trust, previously filed as Exhibit 10.15 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1993, is incorporated herein by reference. 10.13 Agreement for Purchase and Sale and Repurchase Agreement dated as of November 4, 1994 between Fresno-Herndon Partners, Limited and Universal Health Realty Income Trust, previously filed as Exhibit 10.16 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1994, is incorporated herein by reference. 25 10.14 Agreement of Purchase and Sale, and Construction Loan Agreement dated as of December 20, 1994 between Turner Adreac, L.C. and Universal Health Realty Income Trust, previously filed as Exhibit 10.17 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1994, is incorporated herein by reference. 10.15 Sale Agreement, dated as of September 1, 1995, by and among Universal Health Realty Income Trust and Desert Commercial Properties Limited Partnership, previously filed as Exhibit 10.18 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1996, is incorporated herein by reference. 10.16 Operating Agreement of DSMB Properties, L.L.C., dated as of September 1, 1995, by and among Universal Health Realty Income Trust and Desert Commercial Properties Limited Partnership, previously filed as Exhibit 10.19 to the Trust's Annual Report on Form 10-K for the year ended December 31, 1996, is incorporated herein by reference. 10.17 Agreement and Escrow Instructions, dated as of August 15, 1995, by and between Phase III Desert Samaritan Medical Building Partners and Desert Commercial Properties Limited Partnership, previously filed as Exhibit 10.20 to the Trust's Annual Report on 10-K for the year ended December 31, 1996, is incorporated herein by reference. 10.18 Amendment to Credit Agreement dated as of September 27, 1996 by and among Universal Health Realty Income Trust, Corestates Bank, N.A. as agent, NationsBank, N.A., and First Union National Bank, previously filed as Exhibit 10.1 to the Trust's Form 10-Q for the quarter ended September 30, 1996, is incorporated herein by reference. 10.19 Universal Health Realty Income Trust 1997 Incentive Plan, previously filed as Exhibit 10.1 to the Trust's Form 10-Q for the quarter ended September 30, 1997, is incorporated herein by reference. 10.20 Revolving Credit Agreement as of June 24, 1998 among (i) Universal Health Realty Income Trust, a real estate investment trust organized under the laws of the State of Maryland and having its principal place of business at 366 South Gulph Road, King of Prussia, Pennsylvania 19406 (the "Company"), (ii) The Financial Institutions Listed on Schedule 1 Hereto (individually a "Bank" and collectively the "Banks") and (iii) First Union National Bank, as successor by merger to CoreStates Bank, N.A., as administrative agent for the Banks (the "Agent"), previously filed as Exhibit 10.1 to the Trust's Form 10-Q for the quarter ended June 30, 1998, is incorporated herein by reference. 10.21 Amendment No. 1 to Lease, made as of July 31, 1998, between Universal Health Realty Income Trust, a Maryland real estate investment trust ("Lessor"), and Inland Valley Regional Medical Center, Inc., a California Corporation ("Lessee"), previously filed as Exhibit 10.1 to the Trust's Form 10-Q for the quarter ended September 30, 1998, is incorporated herein by reference. 26 10.22 Amendment No. 1 to Lease, made as of July 31, 1998, between Universal Health Realty Income Trust, a Maryland real estate investment trust ("Lessor"), and McAllen Medical Center, L.P. (f/k/a Universal Health Services of McAllen, Inc.), a Texas Limited Partnership ("Lessee"), amends the lease, made as of December 24, 1986, between Lessor and Lessee, previously filed as Exhibit 10.2 to the Trust's Form 10-Q for the quarter ended September 30, 1998, is incorporated herein by reference. 27 Financial Data Schedule 28.1 Dividend Reinvestment Plan for Stockholders, previously filed as Exhibit 28.1 to the Trust's Form 10-Q for the quarter ended March 31, 1987, is incorporated herein by reference. 27 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 8, 1999 UNIVERSAL HEALTH REALTY INCOME TRUST (Registrant) By: /s/ Alan B. Miller Alan B. Miller, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date Signature and Title /s/ Alan B. Miller March 8, 1999 Alan B. Miller, Chairman of the Board and Chief Executive Officer /s/ Kirk E. Gorman March 8, 1999 Kirk E. Gorman, President, Chief Financial Officer, Secretary and Trustee /s/ James E. Dalton March 8, 1999 James E. Dalton, Jr., Trustee /s/ Myles H. Tanenbaum March 8, 1999 Myles H. Tanenbaum, Trustee /s/ Daniel M. Cain March 8, 1999 Daniel M. Cain, Trustee /s/ Miles L. Berger March 8, 1999 Miles L. Berger, Trustee 28 INDEX TO FINANCIAL STATEMENTS AND SCHEDULES Page Report of Independent Public Accountants F-2 Consolidated Balance Sheets - December 31, 1998 and December 31, 1997 F-3 Consolidated Statements of Income - Years Ended December 31, 1998, 1997 and 1996 F-4 Consolidated Statements of Shareholders' Equity - Years Ended December 31, 1998, 1997 and 1996 F-5 Consolidated Statements of Cash Flows - Years Ended December 31, 1998, 1997 and 1996 F-6 Notes to Consolidated Financial Statements - December 31, 1998 F-7 Schedule II - Valuation and Qualifying Accounts - Years Ended December 31, 1998, 1997 and 1996 F-19 Schedule III - Real Estate and Accumulated Depreciation - December 31, 1998 F-20 Notes to Schedule III - December 31, 1998 F-21 F-1 Report of Independent Public AccountantsTo The Shareholders and Board of Trustees ofUniversal Health Realty Income Trust:We have audited the accompanying consolidated balance sheets of Universal HealthRealty Income Trust and Subsidiaries (a Maryland real estate investment trust)as of December 31, 1998 and 1997 and the related consolidated statements ofincome, changes in shareholders' equity and cash flows for each of the threeyears in the period ended December 31, 1998. These financial statements and theschedules referred to below are the responsibility of the Trust's management.Our responsibility is to express an opinion on these financial statements andschedules based on our audits.We conducted our audits in accordance with generally accepted auditingstandards. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.In our opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofUniversal Health Realty Income Trust and Subsidiaries, as of December 31, 1998and 1997 and the consolidated results of their operations and their cash flowsfor each of the three years in the period ended December 31, 1998, in conformitywith generally accepted accounting principles.Our audits were made for the purpose of forming an opinion on the basicfinancial statements taken as a whole. The schedules listed in the Index toFinancial Statements and Schedules on Page F-1 are presented for the purpose ofcomplying with the Securities and Exchange Commission's rules and are not arequired part of the basic financial statements. These schedules have beensubjected to the auditing procedures applied in our audit of the basic financialstatements and, in our opinion, fairly state in all material respects thefinancial data required to be set forth therein in relation to the basicfinancial statements taken as a whole. Philadelphia, Pennsylvania Arthur Andersen LLPJanuary 19, 1999 F-2 Universal Health Realty Income Trust Consolidated Balance Sheets December 31, December 31,Assets: 1998 1997- ------- ------------- ------------- Real Estate Investments: Buildings & improvements $ 142,871,000 $ 143,600,000 Accumulated depreciation (34,006,000) (30,280,000) ------------- ------------- 108,865,000 113,320,000 Land 21,061,000 20,255,000 Construction in progress 28,000 -- Reserve for investment losses (116,000) (89,000) ------------- ------------- Net Real Estate Investments 129,838,000 133,486,000 ------------- ------------- Investments in and advances to limited liability companies 38,165,000 11,075,000Other Assets: Cash 572,000 1,238,000 Bonus rent receivable from UHS 681,000 653,000 Rent receivable from non-related parties 24,000 80,000 Deferred charges and other assets, net 126,000 223,000 ------------- ------------- $ 169,406,000 $ 146,755,000 ============= =============Liabilities and Shareholders' Equity:Liabilities: Bank borrowings $ 64,800,000 $ 41,200,000 Note payable to UHS 1,216,000 1,147,000 Accrued interest 281,000 217,000 Accrued expenses & other liabilities 1,300,000 1,130,000 Tenant reserves, escrows, deposits and prepaid rents 374,000 268,000 Minority interest 87,000 101,000Shareholders' Equity: Preferred shares of beneficial interest, $.01 par value; 5,000,000 shares authorized; none outstanding -- -- Common shares, $.01 par value; 95,000,000 shares authorized; issued and outstanding: 1998 - 8,955,465 1997 - 8,954,840 90,000 90,000 Capital in excess of par value 128,685,000 128,650,000 Cumulative net income 126,458,000 112,121,000 Cumulative dividends (153,885,000) (138,169,000) ------------- ------------- Total Shareholders' Equity 101,348,000 102,692,000 ------------- ------------- $ 169,406,000 $ 146,755,000 ============= =============The accompanying notes are an integral part of these financial statements. F-3 Universal Health Realty Income Trust Consolidated Statements of Income Year ended December 31, -------------------------------------------- 1998 1997 1996 ----------- ----------- ------------Revenues (Note 2): Base rental - UHS facilities $13,764,000 $13,731,000 $13,731,000 Base rental - Non-related parties 6,393,000 5,605,000 4,706,000 Bonus rental 2,966,000 2,844,000 2,735,000 Interest 111,000 584,000 751,000 ----------- ----------- ----------- 23,234,000 22,764,000 21,923,000 ----------- ----------- -----------Expenses: Depreciation & amortization 3,879,000 3,775,000 3,636,000 Interest expense 3,490,000 2,943,000 2,565,000 Advisory fees to UHS (Note 2) 1,161,000 1,099,000 1,044,000 Other operating expenses 1,904,000 1,425,000 1,149,000 ----------- ----------- ----------- 10,434,000 9,242,000 8,394,000 ----------- ----------- ----------- Income before equity in limited liability companies 12,800,000 13,522,000 13,529,000 Equity in income of limited liability companies 1,537,000 445,000 629,000 ----------- ----------- ----------- Net Income $14,337,000 $13,967,000 $14,158,000 =========== =========== =========== Net Income Per Share - Basic $ 1.60 $ 1.56 $ 1.58 =========== =========== =========== Net Income Per Share - Diluted $ 1.60 $ 1.56 $ 1.58 =========== =========== =========== Weighted average number of shares outstanding - Basic 8,952,000 8,952,000 8,952,000 Weighted average number of share equivalents 22,000 15,000 6,000 ----------- ----------- ----------- Weighted average number of shares and equivalents outstanding - Diluted 8,974,000 8,967,000 8,958,000 =========== =========== ===========The accompanying notes are an integral part of these financial statements. F-4 Universal Health Realty Income Trust Consolidated Statements of Shareholders' Equity For the Years Ended December 31, 1998, 1997 and 1996 Common Shares Capital in Number excess of Cumulative Cumulative of Shares Amount par value net income dividends- ----------------------------------------------------------------------------------------------------------------------- January 1, 1996 8,947,192 $ 89,000 $ 128,643,000 $ 83,996,000 ($107,731,000)Net Income -- -- -- 14,158,000 --Issuance of shares ofbeneficial interest 5,148 1,000 -- -- --Dividends ($1.695/share) -- -- -- -- (15,174,000)- -----------------------------------------------------------------------------------------------------------------------January 1, 1997 8,952,340 90,000 128,643,000 98,154,000 (122,905,000)Net Income -- -- -- 13,967,000 --Issuance of shares ofbeneficial interest 2,500 -- 7,000 -- --Dividends ($1.705/share) -- -- -- -- (15,264,000)- -----------------------------------------------------------------------------------------------------------------------January 1, 1998 8,954,840 90,000 128,650,000 112,121,000 (138,169,000)Net Income -- -- -- 14,337,000 --Issuance of shares ofbeneficial interest 625 -- 35,000 -- -- Dividends ($1.755/share) -- -- -- -- (15,716,000)======================================================================================================================= December 31, 1998 8,955,465 $ 90,000 $ 128,685,000 $ 126,458,000 ($153,885,000)=======================================================================================================================The accompanying notes are an integral part of these financial statements. F-5 Universal Health Realty Income Trust Consolidated Statements of Cash Flows Year ended December 31, ---------------------------------------------------- 1998 1997 1996 ------------ ------------ ------------Cash flows from operating activities: Net income $ 14,337,000 $ 13,967,000 $ 14,158,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization 3,879,000 3,775,000 3,636,000 Amortization of interest rate cap 124,000 124,000 125,000 Changes in assets and liabilities: Rent receivable 28,000 (67,000) (47,000) Accrued expenses & other liabilities 170,000 197,000 77,000 Tenant escrows, deposits & prepaid rents 106,000 (247,000) (29,000) Accrued interest 64,000 (17,000) 77,000 Deferred charges & other (53,000) (26,000) 6,000 ------------ ------------ ------------ Net cash provided by operating activities 18,655,000 17,706,000 18,003,000 ------------ ------------ ------------Cash flows from investing activities: Investments in and advances to limited liability companies (27,892,000) (3,741,000) (7,624,000) Acquisitions and additions to land, buildings and CIP (158,000) (4,246,000) (10,195,000) Payments made for construction in progress (28,000) -- (1,246,000) Cash distributions in excess of income from LLCs 863,000 598,000 -- Advances under construction notes receivable -- (3,414,000) (391,000) Repayments under mortgage and construction notes receivable -- 10,262,000 -- ------------ ------------ ------------ Net cash used in investing activities (27,215,000) (541,000) (19,456,000) ------------ ------------ ------------Cash flows from financing activities: Additional borrowings, net of financing costs 23,600,000 -- 16,625,000 Repayment of debt -- (800,000) -- Issuance of shares of beneficial interest 10,000 -- -- Dividends paid (15,716,000) (15,264,000) (15,174,000) ------------ ------------ ------------ Net cash provided by (used in) financing activities 7,894,000 (16,064,000) 1,451,000 ------------ ------------ ------------ (Decrease) increase in cash (666,000) 1,101,000 (2,000) Cash, beginning of period 1,238,000 137,000 139,000 ------------ ------------ ------------Cash, end of period $ 572,000 $ 1,238,000 $ 137,000 ============ ============ ============Supplemental disclosures of cash flow information: Interest paid $ 3,232,000 $ 2,770,000 $ 2,302,000 ============ ============ ============The accompanying notes are an integral part of these financial statements. F-6 Universal Health Realty Income Trust Notes to the Consolidated Financial Statements December 31, 1998(1) Summary of Significant Accounting PoliciesNature of OperationsUniversal Health Realty Income Trust and Subsidiaries (the "Trust") is organizedas a Maryland real estate investment trust. As of December 31, 1998 the Trusthad investments in thirty-one facilities located in fourteen states consistingof investments in healthcare and human service related facilities includingacute care hospitals, behavioral healthcare facilities, rehabilitationhospitals, sub-acute care facilities, surgery centers, childcare centers andmedical office buildings, seven of which are leased to subsidiaries of UniversalHealth Services, Inc., ("UHS").Federal Income TaxesNo provision has been made for federal income tax purposes since the Trust qualifies as a real estate investment trust under Sections 856 to 860 of theInternal Revenue Code of 1986, and intends to continue to remain so qualified.As such, it is required to distribute at least 95 percent of its real estateinvestment taxable income to its shareholders.The Trust is subject to a federal excise tax computed on a calendar year basis.The excise tax equals 4% of the excess, if any, of 85% of the Trust's ordinaryincome plus 95% of any capital gain income for the calendar year over cashdistributions during the calendar year, as defined. No provision for excise taxhas been reflected in the financial statements as no tax was due.Earnings and profits, which will determine the taxability of dividends toshareholders, will differ from net income reported for financial reportingpurposes due to the differences for federal tax purposes in the cost basis ofassets and in the estimated useful lives used to compute depreciation and therecording of provision for investment losses.Real Estate PropertiesThe Trust records acquired real estate at cost and uses the straight-line methodof depreciation for buildings and improvements over estimated useful lives of 25to 45 years.It is the Trust's policy to review the carrying value of long-lived assets forimpairment whenever events or changes in circumstances indicate that thecarrying value of such assets may not be recoverable. Measurement of theimpairment loss is based on the fair value of the asset. Generally, fair valuewill be determined using valuation techniques such as the present value ofexpected future cash flow.The Trust invests primarily in healthcare-related facilities and, therefore, issubject to certain industry risk factors, which directly impact the operatingresults of its lessees. In recent years, an increasing number of legislativeinitiatives have been introduced or proposed in Congress and in statelegislatures that would effect major changes in the healthcare system, eithernationally or at the state level. In addition, the healthcare industry has beencharacterized in recent years by F-7increased competition and consolidation.In assessing the carrying value of the Trust's real estate investments forpossible impairment, management reviews estimates of future cash flows expectedfrom each of its facilities and evaluates the creditworthiness of its lesseesbased on their current operating performance and on current industry conditions.Management of the Trust is unable to predict the effect, if any, that theindustry factors discussed above will have on the operating results of itslessees or on their ability to meet their obligations under the terms of theirleases with the Trust. In addition, management of the Trust cannot predictwhether any of the leases will be renewed on their current terms or at all. As aresult, management's estimate of future cash flows from its leased propertiescould be materially affected in the near term, if certain of the leases are notrenewed at the end of their lease terms.Investments in Limited Liability CompaniesThe consolidated financial statements of the Trust include the accounts of itscontrolled investments. In accordance with the American Institute of CertifiedPublic Accountants' Statement of Position 78-9 "Accounting for Investments inReal Estate Ventures" and Emerging Issues Task Force Issue 96-16, "Investor'sAccounting for an Investee When the Investor Has a Majority of the VotingInterest but the Minority Shareholder or Shareholders Have Certain Approval orVeto Rights", the Trust accounts for its investment in limited liabilitycompanies which it does not control using the equity method of accounting. Theseinvestments, which represent 33% to 99% non-controlling ownership interests, arerecorded initially at the Trust's cost and subsequently adjusted for the Trust's net equity in income and cash contributions and distributions.Earnings Per ShareBasic earnings per share are based on the weighted average number of commonshares outstanding during the year. Diluted earnings per share are based on theweighted average number of common shares during the year adjusted to give effectto common stock equivalents.Stock-Based CompensationStatement of Financial Accounting Standards ("SFAS") No. 123, "Accounting forStock-Based Compensation" encourages a fair value based method of accounting foremployee stock options and similar equity instruments, which generally wouldresult in the recording of additional compensation expense in the Trust'sfinancial statements. The Statement also allows the Trust to continue to accountfor stock-based employee compensation using the intrinsic value-based method ofaccounting as prescribed by Accounting Principals Board ("APB") Opinion No. 25,"Accounting for Stock Issued to Employees." The Trust has adopted thedisclosure-only provisions of SFAS No. 123. Accordingly, no compensation costhas been recognized for the stock option plans in the accompanying financialstatements.Statements of Cash FlowsFor purposes of the Consolidated Statements of Cash Flows, the Trust considersall highly liquid investment instruments with original maturities of threemonths or less to be cash equivalents. F-8Interest Rate Protection AgreementsIn managing interest rate exposure, the Trust at times enters into interest rateswap agreements and interest rate cap agreements. When interest rates change,the differential to be paid or received under the Trust's interest rate swapagreements is accrued as interest expense. Premiums paid for purchased interestrate cap agreements are amortized to interest expense over the terms of thecaps. Unamortized premiums are included in deferred charges in the accompanyingbalance sheet. Amounts receivable under the cap agreements are accrued as areduction of interest expense.Fair Value of Financial InstrumentsThe fair value of the Trust's interest rate swap agreements and investments arebased on quoted market prices. The carrying amounts reported in the balancesheet for cash, accrued liabilities, and short-term borrowings approximate theirfair values due to the short-term nature of these instruments. Accordingly,these items have been excluded from the fair value disclosures includedelsewhere in these notes to consolidated financial statements.Comprehensive IncomeIn June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No.130, "Reporting Comprehensive Income". The standard establishes additionaldisclosure for the elements of comprehensive income and a total comprehensiveincome calculation. Net income as reported by the Trust reflects totalcomprehensive income for the years ended December 31, 1998, 1997 and 1996.Use of EstimatesThe preparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates. Accounting Pronouncement Not Yet AdoptedIn June 1998, the FASB issued SFAS No. 133, "Accounting for DerivativeInstruments and Hedging Activities." The Statement establishes accounting andreporting standards requiring that every derivative instrument (includingcertain derivative instruments embedded in other contracts) be recorded in thebalance sheet as either an asset or liability measured at its fair value. TheStatement requires that changes in the derivative's fair value be recognizedcurrently in earnings unless specific hedge accounting criteria are met. Specialaccounting for qualifying hedges allows a derivative's gains and losses tooffset related results on the hedged item in the income statement, and requiresthat a company must formally document, designate, and assess the effectivenessof transactions that receive hedge accounting. F-9SFAS No. 133 is effective as of the beginning of fiscal years beginning afterJune 15, 1999. A company may also implement the SFAS No. 133 as of the beginningof any fiscal quarter after issuance. SFAS No. 133 cannot be appliedretroactively. SFAS No. 133 must be applied to: (a) derivative instruments, and;(b) certain derivative instruments embedded in hybrid contracts that wereissued, acquired, or substantially modified after December 31, 1997 (and at theTrust's election, before January 1, 1998).The Trust has not yet quantified the impact of adopting SFAS No. 133 on itsfinancial statements and has not determined the timing of or method of adoptionof SFAS No. 133. However, SFAS No. 133 could increase the volatility in earningsand other comprehensive income.ReclassificationsCertain prior year amounts have been reclassified to conform with current yearfinancial statement presentation.(2) Related Party TransactionsUHS of Delaware, Inc. (the "Advisor"), a wholly-owned subsidiary of UHS, servesas Advisor to the Trust under an Advisory Agreement dated December 24, 1986between the Advisor and the Trust (the "Advisory Agreement"). Under the AdvisoryAgreement, the Advisor is obligated to present an investment program to theTrust, to use its best efforts to obtain investments suitable for such program(although it is not obligated to present any particular investment opportunityto the Trust), to provide administrative services to the Trust and to conductthe Trust's day-to-day affairs. In performing its services under the AdvisoryAgreement, the Advisor may utilize independent professional services, includingaccounting, legal and other services, for which the Advisor is reimburseddirectly by the Trust. The Advisory Agreement expires on December 31 of eachyear; however, it is renewable by the Trust, subject to a determination by theIndependent Trustees that the Advisor's performance has been satisfactory. TheAdvisory Agreement may be terminated for any reason upon sixty days writtennotice by the Trust or the Advisor. The Advisory Agreement has been renewed for1999. All transactions with UHS must be approved by the Independent Trustees.The Advisory Agreement provides that the Advisor is entitled to receive anannual advisory fee equal to .60% of the average invested real estate assets ofthe Trust, as derived from its consolidated balance sheet from time to time. Inaddition, the Advisor is entitled to an annual incentive fee equal to 20% of theamount by which cash available for distribution to shareholders, as defined inthe Advisory Agreement, for each year exceeds 15% of the Trust's equity as shownon its balance sheet, determined in accordance with generally acceptedaccounting principles without reduction for return of capital dividends. Noincentive fees were paid during 1998, 1997 and 1996. The advisory fee is payablequarterly, subject to adjustment at year end based upon audited financialstatements of the Trust.For the years ended December 31, 1998, 1997 and 1996, 71%, 72% and 74%,respectively, of the Trust's revenues were earned under the terms of the leases with wholly-owned subsidiaries of UHS. The leases to subsidiaries of UHS areguaranteed by UHS and cross-defaulted with one another. F-10During the third quarter of 1998, wholly-owned subsidiaries of UHS exercisedfive-year renewal options on four hospitals owned by the Trust which werescheduled to expire in 1999 through 2001 (Virtue Street Pavilion, The Bridgeway,Inland Valley Regional Medical Center and Wellington Regional Medical Center).The leases on these facilities were renewed at the same lease rates and terms asthe initial leases and these renewals remove the majority of the previouslydisclosed uncertainty regarding the lease renewals with subsidiaries of UHS. Aspart of the renewal agreement, the Trust also agreed to grant additional fixedrate renewal options to a wholly-owned subsidiary of UHS commencing in 2022 onthe real property of McAllen Medical Center. The leases on the four renewedfacilities represented 30% of the Trust's rental revenue for the twelve monthperiod ended December 31, 1998. On a combined basis, these four facilities hadearnings before interest, taxes, depreciation, amortization and lease and rentalexpense (EBITDAR) for the twelve month period ended December 31, 1998 of 1.8times the total annual rent payable to the Trust in 1998 (ranging from 1.2 to3.0). The remaining UHS facilities, including McAllen Medical Center, had acombined EBITDAR for the twelve month period ended December 31, 1998 of 7.7times the total annual rent payable to the Trust in 1998 (ranging from 1.1 to8.6). The lease on one UHS facility, which had EBITDAR for the twelve monthperiod ended December 31, 1998 of 1.1 times the rent payable to the Trust,expires in 2000 and represented approximately 5% of the Trust's rental revenuefor the twelve month period ended December 31, 1998. Management of the Trust cannot predict whether the leases with subsidiaries of UHS, which have renewaloptions at existing lease rates, or any of the Trust's other leases, will berenewed at the end of their initial term or first five-year renewal term.In recent years, an increasing number of legislative initiatives have beenintroduced or proposed in Congress and in state legislatures that would effectmajor changes in the healthcare system, either nationally or at the state level.In addition, the healthcare industry had been characterized in recent years byincreased competition and consolidation. Management of the Trust is unable topredict the effect, if any, these industry factors will have on the operatingresults of its lessees, including the facilities leased to subsidiaries of UHS,or on their ability to meet their obligations under the terms of their leaseswith the Trust.Revenues received from UHS and from other non-related parties were as follows: Year Ended December 31, 1998 1997 1996 ----------------------------------------------- Base rental - UHS facilities $13,764,000 $13,731,000 $13,731,000Base rental - Non-related parties 6,393,000 5,605,000 4,706,000 ----------- ----------- ----------- Total base rental 20,157,000 19,336,000 18,437,000 ----------- ----------- -----------Bonus rental - UHS facilities 2,737,000 2,615,000 2,506,000Bonus rental - Non-related parties 229,000 229,000 229,000 ----------- ----------- ----------- Total bonus rental 2,966,000 2,844,000 2,735,000 ----------- ----------- -----------Interest - Non-related parties 111,000 584,000 751,000 ----------- ----------- ----------- Total revenues $23,234,000 $22,764,000 $21,923,000 =========== =========== ===========At December 31, 1998, approximately 8% of the Trust's outstanding shares ofbeneficial interest were held by UHS. The Trust has granted UHS the option topurchase Trust shares in the future at fair market value to enable UHS tomaintain a 5% interest in the Trust. maintain a 5% interest in the Trust. F-11The Trust's officers are all employees of UHS and as of December 31, 1998, theTrust had no salaried employees and paid no cash compensation. In 1999, theTrustees awarded a $50,000 bonus to Mr. Kirk E. Gorman, President, ChiefFinancial Officer, Secretary and Trustee of the Trust. UHS agreed to a $50,000reduction in the 1999 advisory fee paid by the Trust.(3) Acquisitions and Dispositions1998 - During 1998, the Trust added five new investments to its portfolioconsisting of the following: (i) the purchase of a 99% equity interest in alimited liability company ("LLC"), that owns Desert Springs Medical Plazalocated in Las Vegas, Nevada ($10.1 million); (ii) the purchase of a 95% equityinterest in a LLC that owns the Edwards Medical Plaza located in Phoenix,Arizona ($3.8 million); (iii) the purchase of a 95% equity interest in a LLCthat owns the Pacifica Palms Medical Plaza located in Torrance, California ($1.7million); (iv) the purchase of a 48% equity interest in a LLC that owns the St.Jude Heritage Health Complex located in Fullerton, California ($1.4 million),and; (v) the purchase of an 80% equity interest in a LLC that owns the RioRancho Medical Center, a medical office building located in Rio Rancho, NewMexico ($900,000). In connection with the purchase of equity interest in LLCsthat own the Pacifica Palms Medical Plaza, the St. Jude Heritage Health Complexand the Rio Rancho Medical Center, the Trust advanced a total of $10.0 millionof short term loans to three separate LLCs. The loans, which earned interest ata combined average annual rate of 9% during 1998, are expected to be fullyrepaid to the Trust during 1999.1997 - During 1997, the Trust added new investments to its portfolio consistingof the following: (i) the purchase of a capital addition to one of its medicaloffice buildings and two additional properties located in Louisiana and Georgia($1.4 million); (ii) the purchase of a 75% equity interest in a LLC thatpurchased the Thunderbird Paseo Medical Plaza ($1.9 million); (iii) thecompletion of construction of The Cypresswood Professional Center, located inHouston, Texas in which the Trust has a 77% controlling equity interest ($4.4million including $1.2 million of construction in progress capitalized during1996), and; (iv) the completion of construction of Samaritan West Valley MedicalCenter located in Goodyear, Arizona in which the Trust owns a 89% equityinterest in a LLC which owns the real estate assets of the facility ($1.8million).1996 - During 1996, the Trust added eleven new investments to its portfolioconsisting of the following: (i) the purchase of a 50% equity interest in a LLCwhich owns three medical office buildings located on the campus of DesertSamaritan Hospital in Phoenix, Arizona ($5.0 million); (ii) the purchase of fourpreschool and child-care centers located in southeastern Pennsylvania ($3.9million); (iii) the acquisition of a 33% equity interest in a LLC which owns amedical office building located on the campus of Columbia/HCA HealthcareCorporation's 260-bed Suburban Medical Center in Louisville, Kentucky; (iv) thepurchase of multi-tenant medical office building adjacent to the SouthernRegional Medical Center in Riverdale, Georgia ($6.2 million); (v) the purchaseof a 50% equity interest in a LLC which owns two medical office buildings on thecampus of Maryvale Samaritan Hospital located in Phoenix, Arizona ($1.4million); (vi) the purchase of a 95% equity interest in a LLC which purchasedthe Desert Valley Medical Center, a medical office building located on thecampus of the Columbia Paradise Valley Hospital in Phoenix, Arizona ($4.3million including $2.7 million of long-term, non-recourse debt); (vii)construction financing provided to a limited partnership, of which the Trustowns a 77% controlling equity interest, for the construction of The CypresswoodProfessional Center located in Houston, Texas ($1.2 million advanced as ofDecember 31, 1996 including a $343,000 capital contribution), and; (viii)construction financing provided to a LLC (excluding F-12$525,000 of capital to be contributed by the Trust upon completion of the centerin the fourth quarter of 1997), of which the Trust owns a 50% initial equity interest, for the construction of Samaritan West Valley Medical Center locatedin Goodyear, Arizona ($391,000 advanced as of December 31, 1996). In connectionwith the Trust's acquisition of a 33% equity interest in the LLC which owns themedical office building on the campus of Suburban Medical Center, the Trustposted a $3.5 million standby letter of credit for the benefit of the lenderproviding the financing. Construction on The Cypresswood Professional Center andthe Samaritan West Valley Medical Center was completed in the third and fourthquarters of 1997, respectively.(4) LeasesAll of the Trust's leases are classified as operating leases with initial termsranging from 5 to 15 years with up to six five-year renewal options. Under theterms of the leases, the Trust earns fixed monthly base rents and may earnperiodic additional rents (see Note 2). The additional rent payments aregenerally computed as a percentage of the facility's net patient revenue or CPIincrease in excess of a base amount. The base year amount is typically netpatient revenue for the first full year of the lease. The Trust records theseadditional rents on a pro rata basis over the annual lease period if theachievement of the specific net patient revenue target amounts is probable.Minimum future base rents on non-cancelable leases are as follows: 1999 $ 19,373,000 2000 19,180,000 2001 18,116,000 2002 11,442,000 2003 10,616,000 Later Years 24,360,000 ------------- Total Minimum Base Rents $103,087,000 ============Under the terms of the hospital leases, the lessees are required to pay alloperating costs of the properties including property insurance and real estatetaxes. Tenants of the medical office buildings generally are required to paytheir pro-rata share of the property's operating costs above a stipulatedamount.(5) DebtThe Trust has a $80 million unsecured non-amortizing revolving credit agreement(the "Agreement"), which expires on June 24, 2003. The Agreement provides forinterest at the Trust's option, at the certificate of deposit rate plus 5/8% to1 1/8%, Eurodollar rate plus 1/2% to 1 1/8% or the prime rate. A fee of .175% to .375% is required on the unused portion of this commitment. The margins over thecertificate of deposit rate, Eurodollar rate and the commitment fee are basedupon the Trust's debt to total capital ratio as defined by the Agreement. AtDecember 31, 1998 the applicable margin over the certificate of deposit andEurodollar rates were 7/8% and 5/8%, respectively, and the commitment fee was .20%. There are no compensating balance requirements. The Agreement contains aprovision whereby the commitments will be reduced by 50% of the proceedsgenerated from any new equity offering. F-13At December 31, 1998, the Trust had approximately $12 million of availableborrowing capacity.The average amounts outstanding under the revolving credit agreement during1998, 1997 and 1996 were $49,195,000, $40,774,000 and $34,410,000, respectively,with corresponding effective interest rates, including commitment fees but notincluding the effect of interest rate swaps of 6.3%, 6.4% and 6.3%. The maximumamounts outstanding at any month end were $64,800,000, $44,300,00 and$42,200,000 during 1998, 1997 and 1996, respectively.Covenants relating to the revolving credit facility require the maintenance of a minimum tangible net worth and specified financial ratios, limit the Trust'sability to incur additional debt, limit the aggregate amount of mortgagereceivables and limit the Trust's ability to increase dividends in excess of 95%of cash available for distribution, unless additional distributions are requiredto comply with the applicable section of the Internal Revenue Code and relatedregulations governing real estate investment trusts.The Trust has entered into interest rate swap agreements and an interest ratecap agreement which are designed to reduce the impact of changes in interestrates on its floating rate revolving credit notes. The Trust has threeoutstanding swap agreements for notional principal amounts of $5 million, $4million and $1,580,000 which mature in May, 1999, July, 2002 and May, 2001,respectively. These swap agreements effectively fix the interest rate on$10,580,000 of variable rate debt at 7.56% including the revolver spread of .625%. The interest rate cap, for which the Trust paid $622,750, (unamortizedpremium of $62,000 at December 31, 1998) matures in June, 1999 and fixes themaximum rate on $15 million of variable rate revolving credit notes at 7.625%including the revolver spread of .625%. The interest rate swap and capagreements were entered into in anticipation of certain borrowing transactionsmade by the Trust during 1995, 1996 and 1997. The effective rate on the Trust'srevolving credit notes including commitment fees and interest rate swap expensewas 6.7%, 6.9% and 6.8% during 1998, 1997 and 1996, respectively. Additionalinterest expense recorded as a result of the Trust's hedging activity, which isincluded in the effective interest rates shown above, was $136,000, $118,000 and$130,000 in 1998, 1997 and 1996, respectively. The Trust is exposed to creditloss in the event of nonperformance by the counterparties to the interest rateswap and cap agreements. These counterparties are major financial institutionsand the Trust does not anticipate nonperformance by the counterparties which arerated A or better by Moody's Investors Service. Termination of the interest rateswaps at December 31, 1998 would have resulted in payments to the counterpartiesof approximately $322,000 and termination of the interest rate cap would havehad no impact on the Trust. The fair value of the interest rate swap and capagreements at December 31, 1998 reflects the estimated amounts that the Trustwould pay or receive to terminate the contracts and are based on quotes from thecounterparties.(6) DividendsDividends of $1.755 per share were declared and paid in 1998, of which $1.682per share was ordinary income and $.073 per share was a return of capitaldistribution. Dividends of $1.705 per share were declared and paid in 1997, ofwhich $1.624 per share was ordinary income and $.081 per share was a return ofcapital distribution. Dividends of $1.695 per share were declared and paid in1996, of which $1.622 per share was ordinary income and $.073 per share was areturn of capital distribution. F-14(7) Incentive PlansIn 1991, the Trustees adopted a share compensation plan for Trustees who areneither employees nor officers of the Trust ("Outside Trustees"). Pursuant tothe plan, each Outside Trustee may elect to receive, in lieu of all or a portionof the quarterly cash compensation for services as a Trustee, shares of theTrust based on the closing price of the shares on the date of issuance. As ofDecember 31, 1998 no shares have been issued under the terms of this plan.During 1992 and 1993, the Trust granted options pursuant to the 1988Non-Statutory Stock Option Plan. Pursuant to the terms of this plan, whichexpired in December of 1998, the granted options vested ratably 25% per yearbeginning one year after the date of grant and expired ten years from the grantdate. As of December 31, 1998, 58,024 options were outstanding and exercisableat an aggregate purchase price of $973,137 or $16.77 per share.During 1997, the Trust's Board of Trustees approved the Universal Health RealtyIncome Trust 1997 Incentive Plan ("The Plan"), which is a newly created stockoption and dividend equivalents rights plan for employees of the Trust,including officers and directors. There are 400,000 shares reserved for issuance under The Plan. All stock options were granted with an exercise price equal tothe fair market value on the date of the grant. The options granted vest ratablyat 25% per year beginning one year after the date of grant, and expire in tenyears. Dividend equivalent rights reduce the exercise price of the 1997Incentive Plan options by an amount equal to the cash or stock dividendsdistributed subsequent to the date of grant. On June 23, 1997, there were 70,000stock options with dividend equivalent rights granted to officers and trusteesof the Trust. The Trust recorded expenses relating to the dividend equivalentrights of $123,000 in 1998 and $60,000 in 1997. As of December 31, 1998, therewere 16,250 options exercisable under The Plan with an average exercise price,adjusted to give effect to the dividend equivalent rights, of $16.02 per share.SFAS No. 123 requires the Trust to disclose pro-forma net income and pro-formaearnings per share as if compensation expense were recognized for optionsgranted beginning in 1995. Because the SFAS No. 123 method of accounting has notbeen applied to options granted prior to January 1, 1995 and since there were nostock options granted by the Trust during 1995 or 1996, no pro forma disclosuresare required. Using this approach, the Trust's net earnings and earnings pershare would have been the pro forma amounts indicated below:Year Ended December 31 1998 1997 - --------------------------------------------------------------------------------Net Income: As Reported $14,337,000 $13,967,000 Pro Forma $14,201,000 $13,898,000Earnings Per Share: As Reported: Basic $ 1.60 $ 1.56 Diluted $ 1.60 $ 1.56Pro Forma: Basic $ 1.59 $ 1.55 Diluted $ 1.58 $ 1.55 F-15The fair value of each option grant was estimated on the date of grant using theBlack-Scholes option-pricing model with the following range of assumptions usedfor the three option grants that occurred during 1998 and 1997:Year Ended December 31 1998 1997 - ----------------------------------------------------------------------------Volatility 15% 15%Interest rate 5% - 6% 6.5%Expected life (years) 7.9 7.9Forfeiture rate 2% 2%- ----------------------------------------------------------------------------Stock-based compensation costs on a pro forma basis would have reduced netincome by $136,000 in 1998 and $69,000 in 1997. Because the SFAS No. 123 methodof accounting has not been applied to options granted prior to January 1, 1995,the resulting pro forma disclosures may not be representative of that to beexpected in future years.Stock options to purchase shares of beneficial interest have been granted toofficers and directors of the Trust under various plans. Information withrespect to these options is summarized as follows: Number of Average Option Range Outstanding Options Shares Price (High-Low)- -------------------------------------------------------------------------------------------- Balance, January 1, 1996 95,000 $16.80 $16.875/$16.125 Granted 0 N/A N/A Exercised (36,976) $16.84 $16.875/$16.125 Cancelled 0 N/A N/A- -------------------------------------------------------------------------------------------- Balance, January 1, 1997 58,024 $16.77 $16.875/$16.125 Granted 70,000 $18.625 $18.625/$18.625 Exercised 0 N/A N/A Cancelled 0 N/A N/A- -------------------------------------------------------------------------------------------- Balance, January 1, 1998 128,024 $17.79 $18.625/$16.125 Granted 7,500 $19.40 $21.4375/$18.375 Exercised (625) $18.625 $18.625/$18.625 Cancelled (4,375) $18.625 $18.625/$18.625- -------------------------------------------------------------------------------------------- 130,524 $17.85 $21.4375/$16.125- -------------------------------------------------------------------------------------------- F-16(8) Summarized Financial Information of Equity AffiliatesThe following table represents summarized unaudited financial information of thelimited liability companies ("LLCs") accounted for by the equity method. Amountspresented include investments in the following LLCs: Name of LLC Property Owned by LLC ---------------------- ------------------------------------ DSMB Properties Desert Samaritan Hospital MOBs DVMC Properties Desert Valley Medical Center MOBs Parkvale Properties Maryvale Samaritan Hospital MOBs Suburban Properties Suburban Medical Center MOBs Litchvan Investments Samaritan West Valley Medical Center Paseo Medical Properties II Thunderbird Paseo Medical Plaza Willetta Medical Properties Edwards Medical Plaza DesMed Desert Springs Medical Plaza PacPal Investments Pacifica Palms Medical Plaza RioMed Investments Rio Rancho Medical Center West Highland Holdings St. Jude Heritage Health Complex December 31, ----------------------------------- 1998 1997 ----------------------------------- (amounts in thousands) Net property $95,732 $54,536 Other assets 5,430 4,164 Liabilities and third-party debt 58,118 44,261 Loans payable to the Trust 9,980 ----- Equity 33,063 14,439 UHT's share of equity 28,185 11,075 For the Year Ended December 31, ----------------------------------- 1998 1997 ----------------------------------- (amounts in thousands) Revenues $12,942 $8,135 Operating expenses 4,677 2,727 Depreciation & amortization 2,450 1,846 Interest, net 4,133 3,093 Net income 1,682 469 UHT's share of net income 1,537 445As of December 31, 1998, these LLCs had $56.1 million of non-recourse debtpayable to third-party lending institutions. The loans payable to the Trustearned interest at a combined average annual rate of 9% during 1998 and areexpected to be fully repaid to the Trust during 1999 once the LLCs securelong-term, third-party financing. F-17 Aggregate maturities of non-recourse debt payable to third-parties is asfollows: 1999 $10,241 2000 914 2001 4,674 2002 934 2003 1,006 Later 38,312 ------- Total $56,081 =======(9) Quarterly Results (unaudited) 1998- ------------------------------------------------------------------------------------------------------------------------ First Second Third Fourth Quarter Quarter Quarter Quarter Total- ------------------------------------------------------------------------------------------------------------------------ Revenues $5,857,000 $5,793,000 $5,694,000 $5,890,000 $23,234,000Net Income $3,569,000 $3,528,000 $3,471,000 $3,769,000 $14,337,000Earnings Per Share-Basic $0.40 $0.39 $0.39 $0.42 $1.60Earnings Per Share-Diluted $0.40 $0.39 $0.39 $0.42 $1.60 1997- ------------------------------------------------------------------------------------------------------------------------ First Second Third Fourth Quarter Quarter Quarter Quarter Total- ------------------------------------------------------------------------------------------------------------------------Revenues $5,700,000 $5,769,000 $5,560,000 $5,735,000 $22,764,000Net Income $3,658,000 $3,550,000 $3,342,000 $3,417,000 $13,967,000Earnings Per Share-Basic $0.41 $0.40 $0.37 $0.38 $1.56Earnings Per Share-Diluted $0.41 $0.40 $0.37 $0.38 $1.56 F-18 Universal Health Realty Income Trust Schedule II - Valuation and Qualifying Accounts Balance at Charged to Balance beginning costs and at end Description of period expenses Other (a) of periodReserve for Investment Losses: Year ended December 31, 1998 $ 89,000 $ 300,000 ($273,000) $ 116,000 ========= ========= ========= =========Year ended December 31, 1997 $ 151,000 $ 227,000 ($289,000) $ 89,000 ========= ========= ========= =========Year ended December 31, 1996 $ 158,000 $ 220,000 ($227,000) $ 151,000 ========= ========= ========= =========(a) Amounts charged against the reserve. F-19 Schedule III Universal Health Realty Income Trust Real Estate and Accumulated Depreciation - December 31, 1998 (amounts in thousands) Initial Cost to Universal Cost Gross amount Health capitalized at which Realty Subsequent carried Date of Income to acquis- at close Accumu- const- Trust ition of period lated ruction Deprec- or most iation recent Average Building Land & Building & as of significant Date DepreciableDescription Land & Improv. Improv. Land Improvements Total Dec. 31, expansion Acquired Life 1998 or reno- vation- ----------------------------------------------------------------------------------------------------------------------------------- Virtue Street Pavilion $1,825 $9,445 - $1,770 $9,445 $11,215 $3,244 1975 1986 35 YearsChalmette Medical Center 2,000 7,473 - 2,000 7,473 9,473 2,365 1981 1988 34 Years Chalmette, LouisianaInland Valley Regional Medical Center Wildomar, California 2,050 10,701 2,868 2,050 13,569 15,619 3,145 1986 1986 43 YearsMcAllen Medical Center McAllen, Texas 4,720 31,442 10,188 6,281 40,069 46,350 9,262 1994 1986 42 YearsWellington Regional Medical Center West Palm Beach, Florida 1,190 14,652 4,822 1,663 19,001 20,664 4,349 1986 1986 42 YearsThe Bridgeway North Little Rock, Arkansas 150 5,395 499 150 5,894 6,044 2,004 1983 1986 35 YearsMeridell Achievement Center Austin, Texas 1,350 3,782 4,139 1,350 7,921 9,271 2,743 1991 1986 28 YearsTri-State Rehabilitation Hospital Evansville, Indiana 500 6,945 1,062 500 8,007 8,507 1,819 1993 1989 40 YearsVencor Hospital - Chicago Chicago, Illinois 158 6,404 1,907 158 8,311 8,469 3,559 1993 1986 25 YearsFresno-Herndon Medical Plaza Fresno, California 1,073 5,266 24 1,073 5,290 6,363 481 1992 1994 45 YearsFamily Doctor's Medical Office Building Shreveport, Louisiana 54 1,526 494 54 2,020 2,074 141 1991 1995 45 YearsKelsey-Seybold Clinic at King's Crossing 439 1,618 - 439 1,618 2,057 117 1995 1995 45 YearsProfessional Center at King's Crossing 439 1,837 43 439 1,880 2,319 127 1995 1995 45 Years Kingwood, TexasChesterbrook Academy Audubon, Pennsylvania - 996 - - 996 996 59 1996 1996 45 YearsCarefree Learning Center New Britain, Pennsylvania 250 744 - 250 744 994 43 1991 1996 45 YearsCarefree Learning Center Uwchlan, Pennsylvania 180 815 - 180 815 995 48 1992 1996 45 YearsCarefree Learning Center Newtown, Pennsylvania 195 749 - 195 749 944 44 1992 1996 45 YearsThe Southern Crescent Center 1,130 5,092 14 1,130 5,106 6,236 285 1994 1996 45 YearsThe Southern Crescent Center II 806 806 0 806 0 1998 1998 35 Years Riverdale, GeorgiaThe Cypresswood Professional Center Spring, Texas 573 3,842 121 573 3,963 4,536 171 1997 1997 35 Years ------- -------- ------- ------- -------- -------- ------- TOTALS $18,276 $118,724 $26,987 $21,061 $142,871 $163,932 $34,006 ======= ======== ======= ======= ======== ======== ======= F-20 Universal Health Realty Income Trust Notes to Schedule III December 31, 1998(1) Reconciliation of Real Estate PropertiesThe following table reconciles the Real Estate Properties from January 1, 1996to December 31, 1998: 1998 1997 1996 ------------- ------------- ------------- Balance at January 1 $ 163,855,000 $ 158,083,000 $ 147,888,000 Balance at January 1 $ 163,855,000 $ 158,083,000 $ 147,888,000Additions and acquisitions 158,000 4,526,000 10,195,000Reclasses from construction in progress -- 1,246,000 --Dispositions (a) (81,000) -- -- ------------- ------------- -------------Balance at December 31 $ 163,932,000 $ 163,855,000 $ 158,083,000 ============= ============= =============(2) Reconciliation of Accumulated DepreciationThe following table reconciles the Accumulated Depreciation from January 1, 1996to December 31, 1998: 1998 1997 1996 ------------ ------------ ------------ Balance at January 1 $ 30,280,000 $ 26,540,000 $ 22,986,000Current year depreciation expense 3,807,000 3,740,000 3,554,000Dispositions (a) (81,000) -- -- ------------ ------------ ------------Balance at December 31 $ 34,006,000 $ 30,280,000 $ 26,540,000 ============ ============ ============(a) Consists of accumulated depreciation on demolished houses located on land cleared for construction of The Southern Crescent Center II, a new medical office building which is scheduled to open in the first quarter of 2000.The aggregate cost basis and net book value of the properties for Federal incometax purposes at December 31, 1998 are approximately $153,000,000 and$122,000,000, respectively. F-21 [Universal Health Realty Income Trust letterhead] January 7, 1999Mr. Alan B. MillerPresidentUHS of Delaware, Inc.367 South Gulph RoadKing of Prussia, PA 19406Dear Alan: The Board of Trustees of Universal Health Realty Income Trust at theirDecember 1, 1998, meeting authorized the renewal of the current AdvisoryAgreement between the Trust and UHS of Delaware, Inc. ("Agreement") upon thesame terms and conditions. This letter constitutes the Trust's offer to renew the Agreement untilDecember 31, 1999, upon the same terms and conditions. Please acknowledge UHS ofDelaware, Inc.'s acceptance of this offer by signing in the space provided belowand returning one copy of this letter to me. Sincerely yours, /s/ Kirk E. Gorman Kirk E. Gorman President and Secretarycc: Warren J. Nimetz, Esquire Charles BoyleAgreed to and Accepted:UHS OF DELAWARE, INC.By: /s/ Alan B. Miller Alan B. Miller, President 5 0000798783 UNIVERSAL HEALTH REALTY INCOME TRUST 1,000 U.S. DOLLARS YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 1 572 0 5,705 5,116 0 0 163,960 34,006 169,406 0 66,016 0 0 90 101,258 169,406 0 24,771 0 3,065 3,879 0 3,490 14,337 0 14,337 0 0 0 14,337 1.60 1.60