," "ITEM 3. LEGAL PROCEEDINGS", THE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS AND "ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," DESCRIBE CERTAIN FACTORS, AMONG OTHERS, THAT COULD CONTRIBUTE TO OR CAUSE SUCH DIFFERENCES. OTHER FACTORS THAT COULD CONTRIBUTE TO OR CAUSE SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, UNANTICIPATED DEVELOPMENTS IN ANY ONE OR MORE OF THE FOLLOWING AREAS: ENVIRONMENTAL ISSUES, GOVERNMENT REGULATIONS, LABOR COSTS, LIABILITY AND INSURANCE, PENDING OR THREATENED LITIGATION AND INVESTIGATIONS, THE DEPENDENCE ON KEY PERSONNEL, THE OPERATION OF MANAGEMENT INFORMATION AND COMPUTER SYSTEMS AT THE COMPANY'S CUSTOMERS AND VENDORS, AND OTHER RISKS FACTORS WHICH MAY BE DETAILED FROM TIME TO TIME IN THE COMPANY'S SECURITIES AND EXCHANGE COMMISSION FILINGS.

READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON ANY FORWARD-LOOKING STATEMENTS CONTAINED HEREIN, WHICH SPEAK ONLY AS OF THE DATE HEREOF. THE COMPANY UNDERTAKES NO OBLIGATIONS TO PUBLICLY RELEASE THE RESULT OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS THAT MAY BE MADE TO REFLECT EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCE OF UNEXPECTED EVENTS.

ITEM 1. DESCRIPTION OF BUSINESS.

GENERAL

DIVERSIFIED SENIOR SERVICES, INC. ("Diversified") was founded to focus on the development and management of low and moderate income senior housing and assisted living facilities. We specialize in creating affordable community living alternatives for seniors with fixed incomes. Our goal is to offer a continuum of senior living arrangements: apartments managed specifically for the housing needs of elderly persons; enhanced housing providing additional services for convenient, worry free living; and, finally, assisted living residences when a greater level of support is necessary.

We believe that there is a growing demand for senior housing developed for the low and moderate income frail elderly, specifically in our targeted areas of smaller cities and towns throughout the Midatlantic and Southeast. Although we have been operating for less than five years, our senior management has over 20 years of experience in developing and operating housing specifically designed for this target population with a concentration in Eastern North Carolina.

Diversified was formed in May 1996 as a wholly owned subsidiary of Taylor House Enterprises, Limited ("Taylor House") and began operations in July 1996 when Taylor House exchanged all of the stock of its wholly owned subsidiary, Residential Properties Management, Inc., for Diversified's common stock. Taylor House is a privately-held corporation controlled by the Diversified's senior management. We completed our initial public offering in January 1998. Our common stock is quoted under the symbol DISS on the Nasdaq SmallCap Market.

We have focused our development efforts on two types of facilities: 60-unit assisted living residences and 30-unit senior housing residences. We have completed construction of 60-unit residences located in Mocksville, Hamlet, Cherryville, Goldsboro and Rocky Mount, North Carolina. Our first 30-door residences in Pittsboro and Kinston, North Carolina were completed in March and November of this year.

Our 30-unit independent living residences, known as "Somerset House," provide residents 24-hour security and emergency call system, housekeeping, linen service, nutritious meals and activities. Each Somerset House is designed as a large house compatible in style with, and situated in, a small town, residential neighborhood in close proximity to community resources such as churches and the public library. Each house is limited to 30 private apartments to assure a warm, home-like atmosphere. Each apartment has a bedroom area, a living area, a Pullman style kitchen and a private bath.

Our 60-unit assisted living residences, known as "Somerset Court," supplement the services provided in an independent setting by providing personal care services, including medication monitoring, dressing, grooming, mobility, home management and case management. Somerset Courts provide a comfortable home-like environment with a range of common areas to accommodate both large gatherings and small, more intimate groups. Each residence has a furnished, fully carpeted living area with separate entrance and temperature control.

On March 1, 2000 we began managing assisted living properties in Newport and Shelby, North Carolina for a nonprofit owner. On February 22, 2001, we began managing nine assisted living facilities, with approximately 500 residents, seven located in western North Carolina and two in southwestern Virginia. The management of the South Boston, Virginia facility, which we began managing in October 1998, terminated effective February 28, 2001.

In addition to these properties, as of March 23, 2001, our development pipeline includes five additional 60-unit sites and two additional 30-unit sites, all of which are under our control and with positive feasibility studies. We continue to identify additional markets with positive feasibility. We are also exploring the conversion to assisted living of two residential floors in one existing subsidized senior housing complex we manage.

In addition to the sixteen assisted living facilities and two independent living facilities representing 991 potential residents that we currently manage, we also manage apartment complexes. As of March 23, 2001, we managed 52 residences, consisting of approximately 2,068 units located in three states, North Carolina, Pennsylvania and West Virginia.

Our internal growth program will focus on developing and operating 60-unit assisted living facilities and 30-unit independent senior housing residences. In addition to developing these new facilities, we will consider acquiring existing assisted living and senior housing facilities.

Between May 3, 1999 and November 6, 1999, we completed a private placement, funded over three closings, in which we issued 2,225 shares of 12% Series B Cumulative Convertible Preferred Stock. We received net proceeds of approximately $4,022,138 from the private placement. During 2000, preferred shareholders converted a total of 579 shares of the 12% Series B Cumulative Convertible Preferred Stock to a total of 954,584 shares of common stock. During May of 2000, we and the holders of our Series B Preferred Stock amended the purchase agreement pursuant to which the Series B Preferred Stock was sold to allow us to incur, subject to certain conditions, additional bank debt. Immediately after this amendment became effective, we drew down $1,000,000 on our bank facility.

As of March 22, 2001, we and the Series B Preferred Stock holders further amended the Series B Preferred Stock agreements to:

o specify that we will not be deemed to be in default or otherwise subject to penalties if our common stock is delisted from the Nasdaq SmallCap Market, as long as we maintain a listing on the OTC Bulletin Board;

o specify that the failure of the Company's Board of Directors to declare a dividend on the Series B Preferred Stock as of January 1, 2001 will not be deemed a default or otherwise subject us to penalties;

o allow us to issue additional debt, equity or convertible securities if the net proceeds are first used to redeem the Series B Preferred Stock at its stated value plus accumulated but unpaid dividends through the date of redemption; and

o specify that, until September 22, 2001, subject to our actually raising such additional funds, the holders of the Series B Preferred Stock agree to redeem their shares of Series B Preferred Stock at that amount.

In connection with the March 22, 2001 amendments, we agreed that we will exchange 442,222 shares of common stock held by certain holders of Series B Preferred Stock for 497.5 shares of Series B Preferred Stock. Of those shares of common stock, 20,000 had been issued in connection with conversions of Series B Preferred Stock on February 25, 2000 at a conversion price of $2.25 and 422,222 had been issued in connection with conversions of Series B Preferred Stock on March 3, 2000 at a conversion price of $2.25. The net effect of this exchange will be to decrease the number of our outstanding shares of common stock by 422,222 shares and increase the number of our outstanding shares of Series B Preferred Stock by 497.5. We originally designated 3,000 shares of preferred stock as 12% Series B Cumulative Convertible Preferred Stock. Giving effect to the exchange, we will have 277.5 shares of 12% Series B Cumulative Convertible Preferred Stock available for issuance.

Diversified has received trademark protection for both its Somerset House and Somerset Court service marks.

Diversified's executive offices are located at 915 West Fourth Street, Winston-Salem, North Carolina 27101. Our telephone number is (336) 724-1000. Effective May1, 2001, the executive offices will relocate to 1105 Brookstown Avenue, Winston-Salem, North Carolina 27101. Our telephone number will remain the same.

COMPETITION

The assisted living industry is highly competitive and fragmented. There are numerous small operators but also large, public, well-financed competitors. The scope of assisted living services varies substantially from one operator to another and with the requirements of one state to another. We believe that residential style assisted living offers an attractive approach to providing residential and personal care services for the elderly. We believe that (i) the increased emphasis by both federal and state governments on containing costs; (ii) the limitations imposed in many states on the construction of additional skilled nursing facilities; and (iii) the decreasing viability of family care create a positive competitive environment for our residences. The primary consumers of assisted living and senior housing residences are persons over the age of 65.

The competition in managing subsidized housing for the elderly is substantial with competition from numerous local, regional and national companies, many of which have greater financial resources than Diversified. There is increasing demand for such facilities due to the increasing population of elderly in the United States. Growth in this industry is dependent upon the continued availability of government financing and subsidies. We do not anticipate substantial near-term growth in this part of our business nor are we dependent on such growth for future profitability. Our senior management has over twenty years experience in subsidized housing, so we should be positioned to take advantage of this business if and when conditions change.

REGULATORY MATTERS

Diversified's assisted living operations are subject to substantial regulation by governmental agencies. Assisted living facilities are generally subject to less regulation than other licensed health care providers, but more regulation than standard congregate care or independent living facilities. In North Carolina, Diversified's assisted living facilities are licensed as Adult Care Homes with capacities of 21 or more. Adult Care Homes are regulated by the North Carolina Department of Health and Human Services. In August 1997, the North Carolina General Assembly enacted a twelve-month moratorium on newly licensed beds while licensure procedures are studied to determine whether the existing licensure procedures need to be modified. In 1998 and 1999 the moratorium was extended for another twelve months, respectively. It is anticipated that the moratorium will result in stricter licensure procedures in North Carolina.

North Carolina also has regulations applicable to facilities that are not technically assisted living providers but still offer substantially similar services. The regulations primarily require a notice filing with the state and are intended to assure that residents are given sufficient information to choose providers of personal care services that the facility is not licensed to provide. Although we do not believe that our 30-unit senior housing residences are subject to this regulation, we may elect to register our 30-unit facilities until the applicability of the regulation is clarified.

The licensing statutes typically establish physical plant specifications; resident care policies and services, administration and staffing requirements, and emergency service procedures. Diversified's facilities must also comply with the requirements of the Americans With Disabilities Act and are subject to various local building codes and other ordinances, including fire safety codes. Diversified is a provider of services under Medicaid programs and is subject to Medicaid regulations designed to limit fraud and abuse, violations of which could result in civil and criminal penalties and exclusion from participation in Medicaid programs. Diversified believes it is in substantial compliance with all applicable regulatory requirements. No actions are pending against Diversified for non-compliance with any regulatory requirement.

The North Carolina assisted living facilities are anticipated to derive a substantial portion of their revenues from the Division of Social Services ("DSS") and the Division of Medical Assistance ("DMA"), both under the North Carolina Department of Health and Human Services. DSS administers the state program for Special Assistance for Adults ("SA"), and DMA administers the Medicaid program including the reimbursement to assisted living facilities for personal care assistance ("ACH/PC"). In general, persons with incomes under approximately $12,100 per year are eligible to receive payments under SA and ACH/PC. DSS applies a sliding scale to determine the percentage of SA it will pay, with the resident being responsible for any remaining portion.

The North Carolina General Assembly sets the SA and ACH/PC rates. Effective October 1, 2000, the basic SA rate was increased to $1062 per month and the basic ACH/PC rate was increased to $13.67 per day. In addition, Medicaid transportation increased to $.58 per day. For residents that require a higher level of care and are deemed to be "enhanced care" residents the ACH/PC rate paid in addition to basic SA is as follows:

Extra assistance with eating $23.38 per day

Extra assistance with toileting $17.14 per day

Extra assistance with eating and toileting $26.85 per day

Extra assistance with locomotion $2.48 per day

"Enhanced care" residents are those who need extensive assistance or are totally dependent on other persons for eating, toileting or both.

Subsidized apartments are also subject to substantial regulations primarily from HUD/FHA and the Rural Development Agency, as applicable. In most states, subsidized apartments are also subject to state and local building and fire codes. Approximately 54% of the units under management are eligible for rent subsidies under Housing Assistance Payment ("HAP") contracts. The treatment of HAP contracts upon expiration is administered by the United States Department of Housing and Urban Development. Two current HAP contracts affecting our managed properties are up for renewal in 2001, one property is scheduled for renewal while the other property's contract will expire. The effect of the expiration of an individual property's HAP contract without renewal varies and depends on the market rent for the specific market area.

ENVIRONMENTAL MATTERS

Under various federal, state and local environmental laws, ordinances and regulations, a current or previous owner or operator of real property may be held liable for the cost of removal or remediation of certain hazardous or toxic substances, including, without limitation, asbestos-containing materials that could be located on, in or under such property. Such laws and regulations often impose liability whether or not the owner or operator knew of, or was responsible for, the presence of the hazardous or toxic substances. Our activities are not anticipated to generate any environmentally controlled substance other than a limited amount of medical waste. We contract with a third party to properly dispose of waste products. We obtain a Phase I environmental report on all potential development sites before acquisition. The State of North Carolina issued an environmental no-action letter at the request of the owner of our Shelby facility. The no-action letter was requested because of the presence of pollutants upstream and provides that the State of North Carolina does not presently intend to institute environmental proceedings. The no-action letter does not preclude the federal government from instituting its own environmental proceedings against the owner of the property. Although we are not aware of any other material environmental issues affecting any property we operate, as a developer, owner and/or manager of real property environmental concerns could impact the our operations.

EMPLOYEES

As of December 31, 2000, we had 334 employees, 144 of who are full-time. None of our employees are subject to collective bargaining agreements and none of our employees have been on strike in the past three years.