Sotherly Hotels Inc. - Annual Report: 2004 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 31, 2004

OR

For the transition from              to             

Commission file number 001-31906

MHI HOSPITALITY CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code 757/229-5648

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

The aggregate market value of the Registrant’s common stock held by non-affiliates of the registrant was approximately $61,548,000 based on the closing price quoted by the American Stock Exchange on March 29, 2005. As of March 18, 2005, there were 6,704,000 shares of the Registrant’s common stock issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.

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MHI HOSPITALITY CORPORATION

INDEX

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CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information included and incorporated by reference in this Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words, such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and financing plans are forward-looking statements. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to:

Additional factors that could cause actual results to vary from our forward-looking statements are set forth under the Section titled “Risk Factors” in our Registration Statement on Form S-11 (SEC File No. 333118873).

These risks and uncertainties should be considered in evaluating any forward-looking statement contained in this report or incorporated by reference herein. All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.

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PART I

Item 1. Business

Organization and Initial Public Offering

MHI Hospitality Corporation was formed in August 2004 to own full-service upper up-scale and mid-scale hotels located in primary and secondary markets in the mid-Atlantic and Southeastern United States. We are self-advised and own our hotels and conduct our business through MHI Hospitality, L.P., our operating partnership, of which we are the general partner. Our Company owns approximately 63.7% of the partnership units in our operating partnership. Limited partners (including our officers and certain of our directors) own the remaining operating partnership units. We intend to elect to be treated as a real estate investment trust (“REIT”) for federal income tax purposes.

Our portfolio consists of six full-service upper up-scale and mid-scale hotels under well-known brands as the Hilton and Holiday Inn. On December 21, 2004, we completed our initial public offering, commenced operations and thereafter acquired our initial hotel properties. We also acquired two space leases for the common areas of the Shell Island Resort, a condominium resort property located in Wrightsville Beach, North Carolina.

Our initial public offering consisted of the sale of 6,000,000 shares of common stock at a price of $10 per share resulting in gross proceeds of $60 million and net proceeds (after deducting underwriting discounts and offering expenses) of approximately $54.8 million. On January 19, 2005, the Company sold an additional 700,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the exercise of the over-allotment option, resulting in additional net proceeds of approximately $6.5 million. The total net proceeds from the initial public offering and the exercise of the underwriter’s over-allotment option were approximately $61.3 million.

In order for us to qualify as a REIT, we cannot operate our hotels. Therefore, our hotel properties are leased to MHI Hospitality TRS, LLC, our TRS Lessee, which in turn has engaged MHI Hotels Services, an eligible independent management company, to manage our hotels. Our TRS Lessee is a wholly-owned subsidiary of MHI Hospitality TRS Holding, Inc. (collectively, MHI TRS). MHI TRS is a taxable REIT subsidiary for federal income tax purposes.

As of March 18, 2005, we owned six hotel properties, with 1383 rooms.

Our corporate office is located at 814 Capitol Landing Road, Williamsburg, Virginia 23185. Our telephone number is (757) 229-5648.

Initial Properties

The Company acquired its six initial hotel properties upon completion of the IPO for aggregate consideration of approximately $15.0 million in cash, 3,817,036 units of interest in our operating partnership and the assumption of approximately $50.8 million in debt. The six initial hotel properties which comprise our initial portfolio, Hilton Philadelphia Airport, Holiday Inn Brownstone, Holiday Inn Downtown Williamsburg, Hilton Wilmington Riverside, Hilton Savannah DeSoto and Best Western Maryland Inn are located in Pennsylvania, Maryland, Georgia, Virginia and North Carolina.

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The Company also used an additional $3.5 million in cash proceeds to acquire two leasehold interests in Shell Island Resort, a condominium resort property in Wilmington, North Carolina. In order to comply with federal tax regulations attendant to our status as a REIT, the Company is prohibited from directly managing or operating any of its properties, including its leased property. Thus, our operating partnership entered into sublease arrangements to sublease our entire leasehold interests in the property at Shell Island to affiliates of our management company. Our operating partnership receives fixed annual rent and incurs annual lease expenses in connection with the subleases of such property.

See Item 2 of this Form 10-K for additional detail on the initial properties.

Our Strategy

We intend to pursue a growth strategy of purchasing, renovating and upbranding underperforming, full-service hotels while seeking to improve the operating results of our initial portfolio.

Our primary objectives are to enhance stockholder value over time by generating attractive risk-adjusted returns on invested capital, consistently paying distributions to our stockholders and achieving long-term appreciation in the value of our lodging investments. We will seek to grow internally by improving the operating results of our initial hotel properties. We will also seek to invest in additional well-located hotel properties that are underperforming in their respective markets and would benefit from renovation, upbranding or a change in management.

We intend to focus our investment activities on the following types of opportunities that involve the acquisition, renovation and upbranding of underperforming or functionally obsolete hotels with the goal of achieving a total investment that is substantially less than replacement cost of a hotel or the acquisition cost of a market performing hotel:

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By pursuing deep and shallow turn opportunities and implementing our upbranding strategy, we hope to improve revenue and cash flow and increase the long-term value of the hotels we acquire in the future.

We are currently renovating three of our initial hotel properties, one of which is currently underperforming in its marketplace and represents a shallow turn opportunity. As these hotels are located in attractive markets, we believe that these properties are well positioned for future growth and will benefit from improving industry wide market conditions, our renovations and the efforts of our management team.

Acquisition Strategy

We believe the acquisition of hotel properties that are well located and possess sound operating fundamentals, but are underperforming in their respective markets and would benefit from upbranding, renovation or new management currently present the best opportunities to create value in the lodging industry. We may also pursue acquisition opportunities to convert non-hotel properties to use as a hotel.

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Internal Growth Strategy - Our Initial Hotels

We believe the operating results of certain of our existing properties may be improved as a result of renovations that are planned or underway at these hotels. We currently are renovating the Holiday Inn Williamsburg and are extensively renovating the Hilton Philadelphia Airport during the current fiscal year to comply with Hilton relicensing requirements.

The Best Western Maryland Inn is currently underperforming in its market and represents a shallow turn opportunity. We are using approximately $3.9 million of the net proceeds of our initial public offering to fund renovations to the Best Western Maryland Inn and anticipate improved operating results following renovation and upbranding to a Holiday Inn franchise.

Our Principal Agreements

Strategic Alliance Agreement

MHI Hotels Services is currently the management company for each of our initial hotels and our leased condominium resort property.

On December 21, 2004, we entered into a ten-year strategic alliance agreement with MHI Hotels Services pursuant to which (i) MHI Hotels Services agrees to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to MHI Hotel Services, and (ii) unless a majority of our independent directors in good faith concludes for valid business reasons that another management company should manage a hotel owned by us, we agree to offer MHI Hotels Services or its subsidiaries the right to manage hotel properties that we acquire in the United States.

In addition, during the term of the agreement, MHI Hotels Services has the right to nominate one person for election to our board of directors at our annual meeting of stockholders, subject to the approval of such nominee by our Nominating, Corporate Governance and Compensation Committee for so long as certain of our officers and directors, Andrew Sims, Kim Sims, and Christopher Sims, and their families and affiliates, hold, in the aggregate, not less than 1.5 million units or shares of our common stock.

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Lease Agreements

In order for us to qualify as a REIT, neither our company nor the operating partnership or its subsidiaries can operate our hotels directly. Our hotels are leased to our TRS Lessee which has engaged MHI Hotels Services to manage the hotels. Each lease for the hotels will have a non-cancelable term of five years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.

During the term of each lease, the TRS Lessee will be obligated to pay a fixed annual base rent plus a percentage rent and certain other additional charges. Base rent will accrue and be paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, in excess of certain threshold amounts and other revenues for each of the initial hotels and will be paid quarterly.

Management Agreement

Pursuant to the terms of a management agreement, we engaged MHI Hotels Services as the property manager for our six initial hotels, and intend to offer MHI Hotels Services the opportunity to manage any future hotels that we lease to our TRS Lessee. Our executive officers and certain of our directors are also directors of MHI Hotels Services.

Term

The management agreement will have an initial term of 10 years for each of the initial hotels and a term of 10 years for each hotel we acquire in the future. The term of the management agreement with respect to each hotel may be renewed by MHI Hotels Services, upon the mutual agreement of MHI Hotels Services and MHI TRS, subject to the satisfaction of certain performance tests, for two successive periods of five years each, provided that at the time the option to renew is exercised, MHI Hotels Services is not then in default under the management agreement. If at the time of the exercise of any renewal period, MHI Hotels Services is in default, then the exercise of the renewal option will be conditional on timely cure of such default, and if such default is not timely cured, then our TRS Lessee may terminate the management agreement. If MHI Hotels Services desires to exercise any option to renew, it must give our TRS Lessee written notice of its election to renew the management agreement no less than 90 days before the expiration of the then current term of the management agreement.

Any amendment, supplement or modification of the management agreement must be in writing signed by all parties and approved by a majority of our independent directors.

Amounts Payable under the Management Agreement

MHI Hotels Services receives a base management fee, and if the hotels exceed certain financial thresholds, an additional incentive management fee for the management of our hotels.

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The base management fee for each of our initial hotels and for any subsequently acquired hotels will be a percentage of the gross revenues of the hotel and will be due monthly. The applicable percentage of gross revenue for the base management fee for each of our initial hotels is as follows:

Existing Six Hotel Properties

Subsequently Acquired Hotel Properties

The base management fee for a future hotel first leased other than on the first day of the fiscal year will be 2% for the partial year such hotel is first leased and for the first full fiscal year such hotel is managed. There is no fee cap on the base management fee.

The incentive management fee, if any, will be due annually in arrears within 90 days of the end of the fiscal year and will be equal to 10% of the amount by which the gross operating profit of the hotels on an aggregate basis for a given year exceeds the gross operating profit for the same hotels, on an aggregate basis, for the prior year. The incentive fee may not exceed 0.25% of the aggregate gross revenue of all of the hotels included in the incentive fee calculation for the year in which the incentive fee is earned. The calculation of the incentive fee will not include results of hotels for the fiscal year in which they are initially leased, or for the fiscal year in which they are sold, and newly acquired or leased hotels will be included in the calculation beginning in the second full year such hotel is managed. All of our initial properties are eligible for the incentive fee in 2005, with the exception of the Best Western Maryland Inn, which will become eligible in 2006.

Early Termination

The management agreement may be terminated as to one or more of the hotels earlier than the stated term, if certain events occur, including:

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Termination Fees

In certain cases of early termination of the management agreement with respect to one or more of the hotels, we must pay MHI Hotels Services a termination fee, plus any amounts otherwise due to MHI Hotels Services pursuant to the terms of the management agreement. We will be obligated to pay termination fees in the circumstances provided that MHI Hotels Services is not then in default, subject to certain cure and grace periods.

New Manager; Strategic Alliance Agreement

Pursuant to the strategic alliance agreement between us and MHI Hotels Services, we have agreed to engage MHI Hotels Services for the management of any future hotels unless a majority of our independent directors in good faith concludes, for valid business reasons, that another management company should manage these hotels. If the management agreement terminates as to all of the hotels covered in connection with a default under the management agreement, the strategic alliance agreement will also terminate.

Franchise Agreements

Our six initial hotels operate under franchise licenses from national hotel companies.

We anticipate that most of the additional hotels we acquire will be operated under franchise licenses. We believe that the public’s perception of quality associated with a franchisor is an important feature in the operation of a hotel. Franchisors provide a variety of benefits for franchisees, which include national advertising, publicity and other marketing programs designed to increase brand awareness, training of personnel, continuous review of quality standards and centralized reservation systems.

The franchise licenses for our hotels are held by our TRS Lessee. MHI Hotels Services must operate each of our hotels it manages in accordance with and pursuant to the terms of the franchise agreement for the hotel.

The franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the franchisee must comply. Under the franchise licenses, the franchisee must comply with the franchisors’ standards and requirements with respect to:

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Additionally, as the franchisee, our TRS Lessee will be required to pay the franchise fees described below.

The following table sets forth certain information for the franchise licenses our initial six hotel properties:

Tax Status

We intend to elect to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we currently distribute at least 90% of our taxable income (excluding net capital gains) to our stockholders. It is our current intention to adhere to these requirements and maintain our qualification for taxation as a REIT. As a REIT, we generally will not be subject to federal corporate income tax on that portion of our net income

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that is distributed to stockholders. If we fail to qualify for taxation as a REIT in any taxable year, and no relief provision applies, we will be subject to federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and we would be disqualified from re-electing treatment as a REIT until the fifth calendar year after the year in which we failed to qualify as a REIT. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property, and to federal income and excise taxes on our undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.

Environmental Matters

In connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.

We have reviewed reports of Phase I Environmental Site Assessments, or ESA, that were previously prepared for the majority of our initial hotels and conducted within the past 10 years. Our review of the Phase I ESA reports and an asbestos survey on the Hilton Savannah Desoto identified the presence of a diesel underground storage tank and the presence of asbestos-containing material on the property. The diesel underground storage tank was installed in 1967, was modified in 2000 to meet requirements for upgrading of existing underground storage tank systems and, in 2003, underwent and passed an annual tank tightness test certified by the State of Georgia. The tank’s registration is certified every year by the State of Georgia.

The asbestos survey conducted on the property identified asbestos-containing materials, or ACMs, all of which are enclosed behind walls or ceilings, or otherwise not exposed. The presence of these ACMs does not, in our opinion, pose a material legal or financial risk and does not violate any law applicable to the property. Nevertheless, in response to the finding, the hotel voluntarily implemented an Asbestos Operations and Maintenance Program in 1997 giving hotel maintenance staff information on where the asbestos-containing materials are located and how to handle these materials in the event that they come into contact with them. To our knowledge, there have been no subsequent incidents or exposures to ACMs at the hotel.

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Our review of the Phase I ESA conducted on September 23, 2004 at the Hilton Philadelphia Airport identified the presence of ACMs on the property. The assessment recommended that all exposed ACMs be encapsulated or removed and recommended the implementation of an Asbestos Operations and Maintenance Program on the property. The presence of these ACMs does not, in our opinion, pose a material legal or financial risk and does not violate any law applicable to the property. In response to the findings, the hotel voluntarily implemented an Asbestos Operations and Maintenance Program on the property.

We believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.

Employees

As of March 18, 2005, we employed six persons, three of whom work at our corporate office in Williamsburg, Virginia and three of whom work in our offices in Greenbelt, Maryland. All persons employed in the day-to-day operations of the hotels are employees of MHI Hotels Services, the management company engaged by our TRS Lessee to operate such hotels.

Executive Officers

The following table lists our executive officers as of December 31, 2004:

Available Information

We maintain an Internet site, http://www.mhihospitality.com, which contains additional information concerning MHI Hospitality Corporation. We make available free of charge through our Internet site our filings with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We have also posted on this website our Code of Business Conduct and Ethics, Principles of Corporate Governance, and the charters of our Audit and Nominating, Corporate Governance and Compensation Committees of our board of directors. We intend to disclose on our website any changes to, or waivers from, our Code of Business Conduct and Ethics. Information on our Internet site is neither part of nor incorporated into this Form 10-K.

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Item 2. Properties

As of March 29, 2005, we owned the following 6 hotel properties:

The Hilton Philadelphia Airport.

The Hilton Philadelphia Airport is contiguous to the Philadelphia Airport and located approximately eight miles south of Philadelphia’s central business district at 4509 Island Avenue in Philadelphia, Pennsylvania. The property is located within three miles of the new Lincoln Financial Field, Wachovia Spectrum Center and the new Citizens Bank Park which are homes to Philadelphia’s professional football, basketball, ice hockey, and baseball franchises.

The Hilton Philadelphia Airport was opened in 1972 as a Sheraton Hotel and is comprised of 331 guest rooms, including three suites, in a nine-story L-shaped tower. All rooms provide modern conveniences including high-speed internet access. The hotel features a restaurant and full-service bar, as well as an indoor swimming pool, and 10,000 square feet of meeting space. We are renovating the hotel’s public spaces and guest rooms in 2005 to comply with Hilton relicensing requirements. The total cost of the renovation is estimated to be $3.2 million.

Holiday Inn Downtown Williamsburg

The Holiday Inn Downtown Williamsburg, is located one-half mile from Colonial Williamsburg and three and one-half miles from the Busch Gardens amusement and recreation park, at 814 Capitol Landing Road in Williamsburg, Virginia. The Holiday Inn Downtown Williamsburg was built in 1969, and in 1986, the hotel went through major reconstruction adding an indoor pool and a tiered dining facility, among other amenities. The hotel also is convenient to the historic sites of Yorktown and Jamestown, shopping, dining and local golf courses.

The Holiday Inn Downtown Williamsburg is comprised of 137 guest rooms and one suite. All rooms are equipped with high-speed internet access. The hotel also features two restaurants and an indoor swimming pool. We are currently renovating the Holiday Inn. The total cost of the renovations is estimated to be $500,000.

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Holiday Inn Brownstone

The Holiday Inn Brownstone is located near the central Raleigh business district and adjacent to North Carolina State University, at 1707 Hillsborough Street in Raleigh, North Carolina. The Holiday Inn Brownstone was built in 1971 as an independent property and operated as a Hilton for 20 years. We have no current plans for significant renovations of this hotel.

The hotel is comprised of 188 guest rooms in an eight-story building. The property site is also improved with 18 additional and separate apartment suites. All rooms are equipped with high-speed internet access. The hotel features a restaurant with sports bar, an outdoor swimming pool, a fitness facility and 15,000 square feet of meeting space.

The hotel leases land adjacent to the hotel for use as a parking lot. The lease provides for annual rent of $76,104 and expires in August 2016 with options to renew for up to three additional 10-year periods with an option to purchase the leased property at fair market value at the end of the original lease term in August 2016, subject to payment of an annual fee of $9,000 and other conditions.

Hilton Savannah DeSoto

The Hilton Savannah DeSoto hotel is located at 15 East Liberty Street in historic downtown Savannah, Georgia. The Hilton Savannah DeSoto overlooks Madison Square in the center of Savannah’s historic district. The site has been a hotel since 1890 and the current building was constructed in 1968. The hotel offers views of the Savannah skyline and the Savannah River. The Hilton Savannah DeSoto is connected via an enclosed atrium to a luxury condominium building. We have no current plans for significant renovations of this hotel.

The Hilton Savannah DeSoto is a 14-story structure with 246 traditionally-styled guest rooms including five suites and an executive level. High-speed internet access is available to all guest rooms. The hotel also features a restaurant, coffee bar and lounge, outdoor pool, exercise facility, and 20,000 square feel of meeting space.

We currently lease commercial space next to the Hilton Savannah DeSoto for use as an office, retail or conference space, or for any related or ancillary purposes for the hotel. This six year operating lease covers 2,086 square feet, and provides three renewal options for periods of five-years each. We also lease the entire fourteenth floor of the Hilton Savannah DeSoto to the Chatham Club. This lease is for a period of 99 years and was assumed upon the purchase of the property.

Hilton Wilmington Riverside

The Hilton Wilmington Riverside is located five miles from the Wilmington International Airport at 301 N. Water Street in Wilmington, North Carolina. The Hilton Wilmington Riverside was originally constructed in 1971 and improved by expansion in 1999. The property is the only hotel located directly on the downtown Riverwalk and is situated directly across from the USS North Carolina Battleship Memorial. We have no current plans for significant renovations of this hotel.

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The Hilton Wilmington Riverside originally was constructed with 178 rooms and improved by expansion in 1999 to include 101 additional guest rooms for a current total of 279 rooms in a nine-story structure. All rooms are equipped with high-speed internet service. The hotel features a restaurant, a cocktail lounge, outdoor pool, business center and 20,000 square feet of meeting space.

Best Western Maryland Inn

The Best Western Maryland Inn is located near I-95 between Washington, D.C. and Baltimore, Maryland at Route 198 in Laurel, Maryland. We have received approval to rebrand the hotel as a Holiday Inn. The hotel has a food and beverage facility which is connected to the guest rooms via the banquet rooms and a corridor and has its own free standing access and parking which we intend to lease to a nationally recognized franchise food and beverage operation. We currently have a non-binding site location approval for an Outback Steakhouse location. The Best Western Maryland Inn Laurel opened in 1985 with 127 guest rooms and in 1989 completed an addition of 80 rooms for a current total of 207 guest rooms. All rooms are equipped with high-speed internet access. The hotel also features an indoor pool, 8,000 square feet of meeting and banquet space and a business center. We are currently completely renovating the hotel to comply with a Holiday Inn licensing at a total cost of approximately $4.0 million.

Shell Island

The Shell Island Resort, which is located on the beach, is seven miles from the Wilmington International Airport on the northernmost end of Wrightsville Beach, North Carolina. Shell Island Resort is primarily a leisure destination with the majority of its business generated from guests from the Raleigh, Greensboro and Charlotte markets. Shell Island Resort is a condominium hotel and its approximately 160 condominium suites are owned by individual owners. The common areas are owned by the condominium homeowners’ association. We acquired two leases from MHI Hotels LLC and MHI Hotels Two, Inc., affiliates of our management company, MHI Hotels Services, for cash payments aggregating $3.5 million.

One lease relates to the restaurant, kitchens, meeting rooms, ball room, laundry, maintenance shop, offices and certain maid closets. The second lease relates to the resort’s common areas and includes the lobby, swimming pools, outdoor café, front desk, back office, gift shop, certain storage areas, and ingress and egress throughout the building including parking areas.

As a result of federal tax limitations attendant to our status as a REIT, we are prohibited from managing or operating the property directly. Thus, our operating partnership subleases our leasehold interests in the Shell Island Resort to MHI Hotels LLC and MHI Hotels Two, Inc. In connection with such subleases, MHI Hotels LLC and MHI Hotels Two, Inc. pay us a fixed annual rent of $640,000. Our operating partnership pays annual rent of $120,000 under the leases. Other expenses, such as maintenance and utilities, are paid by MHI Hotels LLC and MHI Hotels Services.

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Item 3. Legal Proceedings

We are not involved in any material litigation nor, to our knowledge, is any material litigation threatened against us.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2004.

PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

Market Information

Our common stock trades on the American Stock Exchange under the symbol “MDH”. The following table sets forth, for the indicated period, the high and low sales prices for the common stock, as reported on the American Stock Exchange:

The closing price of our common stock on the American Stock Exchange on March 18, 2005 was $9.59 per share.

Stockholder Information

As of March 18, 2005, there were 3,855 holders of our common stock, including shares held in “street name” by nominees who are record holders and shares held by beneficial owners.

In order to comply with certain requirements related to our qualification as a REIT, our charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.

Use of Proceeds from Registered Securities

On December 15, 2004, the Company’s Registration Statement on Form S-11 (SEC File No. 333118873) was declared effective by the Securities and Exchange Commission.

On December 16, 2004, the Company executed an Underwriting Agreement pursuant to which the Company agreed to sell 6,000,000 shares of common stock to the underwriters named

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therein, with an over-allotment option to purchase up to an additional 900,000 shares. The managing underwriters of the initial public offering were BB&T Capital Markets, Ferris Baker Watts Incorporated, J.J.B. Hilliard, W.L. Lyons, Inc. and Flagstone Securities. The offering closed on December 21, 2004. All 6,000,000 shares were sold at a price to the public of $10 per share. On January 19, 2005, the underwriters exercised a portion of their over-allotment option in the amount of 700,000 shares. The Company’s net proceeds from the offering, after deducting the underwriting discounts and offering expenses, were approximately $61.3 million.

The Company used the net proceeds as follows:

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Unregistered Securities

Operating Partnership Units. In connection with the acquisition of our six initial hotel properties, we issued 3,817,036 units of interest in our operating partnership. The aggregate value of the units was approximately $38 million based on the initial public offering price of our common stock.

Holders of operating partnership units have certain redemption rights, which enable them to cause the operating partnership to redeem their units in exchange for shares of our common stock on a one-for-one basis or, at our option, cash per unit equal to the market price of our common stock at the time of redemption. The number of shares issuable upon exercise of the redemption rights will be adjusted upon the occurrence of stock splits, mergers, consolidations or similar pro-rata share transactions, which otherwise would have the effect of diluting the ownership interests of the limited partners or our stockholders. As of December 31, 2004, the total number of operating partnership units outstanding was 3,817,036. We have agreed to register with the Securities and Exchange Commission prior to December 21, 2005, 3,817,036 shares of our common stock that are issuable upon redemption of the operating partnership units; however, the 3,817,036 operating partnership units cannot be redeemed by the holders prior to December 21, 2005.

The Operating Partnership units were issued in reliance on the exemption set forth in Section 4(2) of the Securities Act and Rule 506 of Regulation D thereunder. Each of the contributors who received units of interest in our operating partnership in exchange for the contribution of our initial properties is an accredited investor under Rule 501 of the Securities Act.

Dividend and Distribution Information

We intend to elect to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To qualify as a REIT, we will be required to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The amount, timing and frequency of distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future. Our ability to pay distributions to our stockholders will depend, in part, upon our receipt of distributions from our operating partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessee, and in turn, upon the management of our properties by our hotel manager. Distributions to our stockholders will generally be taxable to our stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS may retain any after-tax earnings.

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Item 6. Selected Financial Data

The following table sets forth selected historical financial data for MHI Hospitality Corporation beginning with its commencement of operations on December 21, 2004. The table sets forth selected historical financial data for MHI Hotel Services Group. For periods ending prior to December 21, 2004, MHI Hotel Services Group is considered the predecessor to MHI Hospitality Corporation for accounting purposes.

The financial data for MHI Hotels Services Group is comprised of financial information for the entities and interests formerly under common ownership and control by Edgar Sims, Jr., Jeanette Sims, Andrew Sims, Kim Sims and Christopher Sims. MHI Hotels Services Group formerly included three of our initial hotel properties: the Holiday Inn Downtown Williamsburg, the Hilton Wilmington Riverside and the Hilton Savannah DeSoto. Ownership interests in the entities that owned these properties were contributed to our operating partnership upon the completion of our initial public offering. See “Certain Relationships and Related Party Transactions.” The following selected historical financial data for the period December 21, 2004 to December 31, 2004 for MHI Hospitality Corporation and for the period January 1, 2004 to December 20, 2004 and as of December 31, 2003 and for period ended December 31, 2003, 2002 and 2001 for MHI Hotel Services Group were derived from audited combined financial statements contained elsewhere in this Annual Report on Form 10-K. These financial statements have been audited by PKF Witt Mares, PLC (formerly Witt, Mares & Company, PLC) our independent registered public accounting firm. The selected historical financial data for the period ended December 31, 2000 was derived from unaudited financial statements. The audited and unaudited historical financial statements include all adjustments, consisting of normal recurring adjustments, which we consider necessary for a fair presentation of our financial condition and the results of operations as of those dates and for those periods under accounting principles generally accepted in the United States.

The historical financial information for our accounting predecessor, MHI Hotels Services Group, included herein and set forth elsewhere in this Annual Report on Form 10-K is not necessarily indicative of our future performance. In addition, because the information presented below is only a summary and does not provide all of the information contained in our financial statements and those of our predecessor entities, including notes, you should read the following selected historical financial and operating data together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our combined financial statements and related notes included elsewhere in this Annual Report on Form 10-K.

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MHI HOSPITALITY CORPORATION AND PREDECESSOR

SELECTED HISTORICAL FINANCIAL DATA

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¹ As of the period end.

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FFO does not represent cash generated from operating activities as determined by accounting principles generally accepted in the United States of America (“GAAP”) and should not be considered as an alternative to GAAP net income, as an indication of our financial performance, or to cash flow from operating activities as determined by GAAP, as a measure of liquidity. In addition, FFO is not indicative of funds available to fund cash needs, including the ability to make cash distributions.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our operating results for 2004 reflect 11 days of activity commencing December 21, 2004, the date we successfully completed our initial public offering. As a result of our initial public offering, as well as the underwriters’ exercise of their over-allotment option and private placement transactions, we raised net proceeds of approximately $61.3 million. We immediately utilized the proceeds to retire debt and acquire hotels. We currently have approximately $10.0 million available to acquire additional hotel properties, as well as to complete ongoing renovations.

We are a Maryland corporation that was formed in August 2004 to pursue current and future opportunities in the full-service, upper upscale, upscale and midscale segments of the hotel industry. We are self-advised and own our hotels and conduct our business through our operating partnership, MHI Hospitality, L.P. We are the sole general partner of our operating partnership and we own an approximate 63.7% interest in our operating partnership, with the remaining interest initially being held by the contributors of our initial properties as limited partners. We also intend to elect to be treated as a REIT for federal income tax purposes.

We completed our initial public offering in December 2004 and sold 6,000,000 shares of common stock, resulting in net proceeds (after deducting underwriting discounts and offering expenses) of approximately $54.8 million. In conjunction with the initial public offering, we sold an additional 700,000 shares of common stock as a result of the exercise of the underwriters’ over-allotment option in January 2005, resulting in additional proceeds of approximately $6.5 million. In addition, we entered into a $23.0 million Line of Credit with BB&T Capital Markets which will be used to facilitate acquisitions of new hotel properties as deemed appropriate by the Directors of the Company. See “Liquidity and Capital Resources.”

Our portfolio consists of six full-service, upper upscale and midscale hotels. We own a 100% interest in all of our initial hotels. Based on the initial public offering price of $10 per share, the aggregate consideration paid for 100% of the interests our six initial hotels was $105.9 million, including the assumption of $50.8 million of consolidated debt. In accordance with generally accepted accounting principles, the majority interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and minority interests held by the controlling holders of our accounting predecessor in hotels acquired from third parties are recorded at historical cost basis. Minority interests in those entities that comprise our accounting

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predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value. We used approximately $25.2 million of proceeds from the initial public offering to retire the debt on the Holiday Inn Brownstone, the Hilton Philadelphia Airport and the Holiday Inn Downtown Williamsburg. In addition, we acquired leasehold interests in the resort property leases at the Shell Island Resort, Wrightsville Beach, North Carolina for $3.5 million in cash and paid $2.0 million in cash to restructure existing management agreements relating to five of our initial properties. The $2.0 million payment is a non-recurring charge and is recognized in our first accounting period or fiscal period end at December 31, 2004.

In the hotel industry, most categories of operating costs, with the exception of franchise, management, and credit card fees and the costs of the food and beverages served, do not vary directly with revenues. This aspect of our operating costs creates operating leverage, whereby changes in sales volume disproportionately impact operating results. Room revenue is the most important category of revenue and drives other revenue categories such as food and beverage and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:

To qualify as a REIT, we cannot operate hotels. Therefore, our operating partnership leases our hotel properties to our TRS Lessee. Our TRS Lessee engaged MHI Hotel Services to manage our hotels. Our TRS Lessee, and its parent, MHI Hospitality TRS Holding, Inc., are consolidated into our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.

The discussion below relates to MHI Hospitality Corporation as of December 31, 2004 and for the period from December 21, 2004 (commencement of operations) through December 31, 2004. Since both our operating partnership and MHI TRS are controlled by us, our principal source of funds on a consolidated basis will be from the operations of our hotels. Prior to December 21, 2004, the discussion relates to MHI Hotels Services Group the predecessor to MHI Hospitality Corporation for accounting purposes. Securities and Exchange Commission regulations require inclusion of predecessor financial information for the periods prior to MHI Hospitality Corporation’s commencement of operations.

Critical Accounting Policies

The critical accounting policies are described below. We consider these policies critical because they involve difficult management judgments and assumptions, are subject to material change from external factors or are pervasive, and are significant to fully understand and evaluate our reported financial results.

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Investment in Hotel Properties. Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings and 3-10 years for furniture and equipment.

We review our hotel properties for impairment whenever events or changes in circumstances indicate the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause us to perform our review include, but are not limited to adverse changes in the demand for lodging at our properties due to declining national or local economic conditions and/or new hotel construction in markets where our hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operating activities and the proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying value to the related hotel property’s estimated fair market value is recorded and an impairment loss is recognized.

There have been no charges for impairment recorded in 2004, 2003, 2002 or 2001.

We estimate the fair market values of our properties through cash flow analysis taking into account each property’s expected cash flow generated from operations, holding period and expected proceeds from ultimate disposition. These cash flow analyses are based upon significant management judgments and assumptions including revenues and operating costs, growth rates and economic conditions at the time of ultimate disposition. In projecting the expected cash flows from operations of the asset, we base our estimates on future projected net operating income before depreciation and eliminating non-recurring operating expenses, which is a non-GAAP operational measure, and deduct expected capital expenditure requirements. We then apply growth assumptions based on estimated changes in room rates and expenses and the demand for lodging at our properties, as impacted by local and national economic conditions and estimated or known future new hotel supply. The estimated proceeds from disposition are determined as a matter of management’s business judgment based on a combination of anticipated cash flow in the year of disposition, terminal capitalization rate, ratio of selling price to gross hotel revenues and selling price per room.

If actual conditions differ from those in our assumptions, the actual results of each asset’s operations and fair market value could be significantly different from the estimated results and value used in our analysis.

Revenue Recognition. Hotel revenues, including room, food, beverage and other hotel revenues, are recognized as the related services are delivered. We generally consider accounts receivable to be fully collectible; accordingly, no allowance for doubtful accounts is required. If we determine that amounts are uncollectible, which would generally be the result of a customer’s bankruptcy or other economic downturn, such amounts will be charged against operations when that determination is made.

Recent Accounting Pronouncements

FASB Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of indebtedness of Others, requires

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that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The adoption of FIN 45 did not have a material impact on the Company’s results of operations, financial position, or cash flows.

FASB Interpretation No. 46, Consolidation of Variable Interests Entities, an Interpretation of Accounting Research Bulletin No. 51, as amended (“FIN 46R”), requires certain variable interests entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The adoption of FIN 46R did not have a material impact on the Company’s results of operations, financial position or cash flows.

Statement of Financial Accounting Standards No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously many of these financial instruments were classified as equity. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period after June 15, 2003. However, in October 2003, the FASB elected to indefinitely defer implementation of certain provisions of SFAS 150 relating to limited-life subsidiaries created before November 5, 2003. The adoption of SFAS 150 did not have a material impact on the Company’s results of operations, financial position, or cash flows.

In July 2004, the emerging Issues Task Force (“EITF”) published its consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” EITF Issue No. 03-1 addresses the meaning of other than temporary impairment and its application to debt and equity securities within the scope of SFAS No. 115, certain debt and equity securities within the scope of SFAS No. 124, and equity securities that are not subject to the scope of SFAS No. 115 and accounted for under the equity method. In September 2004, the FASB issued FASB Staff Position (“FSP”) EITF Issue No. 03-1-1, which delays the effect date for the recognition and measurement guidance in EITF Issue No. 03-1. In addition, the FASB has issued a proposed FSP to consider whether further application guidance is necessary for securities analyzed for impairment under EITF issue No. 03-1. The Company continues to assess the potential impact that the adoption of the proposed FSP could have on our financial statements.

In December 2004, the FASB issued SFAS No. 153 “Exchanges of Non-monetary Assets – an amendment of APB Opinion No. 29”. This Statement amended APB Opinion No. 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The Company is currently evaluating the impact of this new standard, but believes that it will not have a material impact upon the Company’s financial position, results of operations or cash flows.

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In April 2003, the FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts and hedging activities under SFAS No. 133. The adoption of SFAS No. 149 did not impact our financial statements.

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6 “Participating Securities and the two-class method under FASB Statement 128,” (the “Consensus” or “EITF 03-6”). For purposes of calculating earnings per share, the Consensus requires net income to be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends or other participation payments that are paid or accumulated for the current period. Under this Consensus, undistributed earnings for the period are allocated to participating securities based on the contractual participation rights of the security to share in those current earnings assuming all earnings for the period are distributed. We have no preferred stock issued and therefore this Consensus has no effect on our financial statements. If and when we issue preferred stock, we will follow the Consensus.

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Shared-Based Payment” (“SFAS 123R”). SFAS 123R is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and its related implementation guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services through share-based payment transactions. SFAS 123R requires a public entity to measure the cost of employee services received in exchange for the award of equity instruments based on the fair value of the award at the date of grant. The cost will be recognized over the period during which an employee is required to provide services in exchange for the award. SFAS 123R is effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. The Company intends to adopt the provisions of SFAS 123R effective July 1, 2005. The impact to compensation expense related to the equity instruments outstanding as of December 31, 2004 is not expected to be material, however, the final impact to compensation expense will be dependent on the number of equity instruments granted during any year, including their timing and vesting period, and the method used to calculate the fair value of the awards, among other factors.

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MHI Hospitality Corporation – Period from December 21, 2004 through December 31, 2004.

The hotel industry in general had a strong year in 2004 and our performance and that of our predecessor reflected the improvement in the industry.

Results of operations for the period from December 21, 2004 through December 31, 2004 include the operating activity of six hotels for 11 days. The results of operations for the period from December 21, 2004 through December 31, 2004 are not indicative of future operating results for the six hotels as the fourth quarter, in particular the weeks before and after the Christmas holiday, are traditionally slower periods for business and leisure travel.

Revenue. Revenues for the period from December 21, 2004 through December 31, 2004 were $0.66 million, which included room revenue of $0.4 million and food and beverage revenue of $0.2 million. Average occupancy, ADR, and RevPAR for the period from December 21, 2004 through December 31, 2004 were 37.9%, $77.21, and $29.29, respectively.

Expenses. Total hotel operating expenses, excluding depreciation and amortization, for the period from December 21, 2004 through December 31, 2004 was $0.97 million. Total corporate and general administrative expenses for the period from December 21, 2004 through December 31, 2004 were $3.8 million. Included in corporate and general expenses were one-time charges related to our initial public offering.

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Depreciation and Amortization. Depreciation and amortization for the period from December 21, 2004 through December 31, 2004 was $0.2 million.

Operating Income (Loss). The eleven day period resulted in a Net Operating Loss of $4.1 million.

Interest Expense. Interest Expense was $268,577 during the period from December 21, 2004 to December 31, 2004.

Net Income (Loss). During the eleven day period from December 21, 2004 to December 31, 2004, we posted a net loss of $2.6 million. The loss reported was primarily attributable to one-time charges relating to the Company’s IPO, including a one-time fee of $2.0 million for the amendment and restructuring of management agreements and $1.6 million in formation and start-up costs.

As a result of our operating losses for the period from December 21, 2004 through December 31, 2004, we recorded an income tax benefit of $200,000.

MHI Hotels Services Group —Comparison of period from January 1, 2004 through December 20, 2004 to year ended December 31, 2003

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With respect to the following discussion, note that the results of operations for 2004 include MHI Hotels Services Group’s activity for the period from January 1, 2004 through December 21, 2004 (354 days), whereas the 2003 results of operations include the full year.

Revenue. Total operating revenue increased 5.9% or $1.44 million in 2004 versus 2003. This increase was driven primarily by a 6.2% room revenue increase. All properties showed room revenue increases in 2004 versus 2003. Food and Beverage revenues also posted a positive 4.5% increase in 2004 versus 2003. This is partially due to increased occupancy, but also to an increase in banquet and meeting functions.

ADR, RevPar and Occupancy all increased over 2003 levels. ADR increased $6.40 or 6.5%. RevPar increased 9.8% or $6.47, while occupancy was up 3.1% to 69.4% for the year versus 67.3% in 2003.

Operating Expenses. Operating expenses increased 1.8% in 2004 over 2003 despite the increase in occupancy and sales. The relatively minor increase in operating expense was attributable to strong cost controls and relatively low labor costs.

Depreciation and Amortization. Depreciation and amortization reflects the continued depreciation of assets which have been on the books for a considerable period of time. The decline in this expense (16.2%) is consistent with the trend over the past few years as certain assets become fully depreciated.

Net Operating Income. Net Operating Income increased by 37.1% or $1.1 million. The increase in Net Operating Income is directly attributable to strong expense controls and rising revenues. Increased ADR and occupancy have driven revenues up particularly in the Savannah and Wilmington markets.

Interest Expense - The decline in interest expense reflects the continued amortization of outstanding indebtedness. This, combined with reduced balances on lines of credit, resulted in lower interest expenses for the year.

Net Income - Net Income increased by 610.3% or $853,000. This reflects management’s ability to hold down operating costs while at the same time driving higher revenues higher. Combined with lower interest costs, this trend has allowed our predecessor to post a strong gain in 2004. We expect cost containment efforts to continue to be successful in the near term which, with improved occupancy rates in our markets, will contribute to potential improvements in net income.

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MHI Hotel Services Group – Comparison of year ended December 31, 2003 to year ended December 31, 2002

Overview. The hotel industry had a very challenging year in 2003. In addition, our hotel properties in Wilmington and Williamsburg, Virginia suffered significant revenue losses due to the impact of Hurricane Isabel in the second half of 2003.

Revenues. Total operating revenue increased $0.5 million, or 2.0%, from $23.9 million in 2002 to $24.4 million in 2003. This increase was due primarily to $1.1 million in growth from the Hilton Wilmington Riverside, partially offset by a drop of $0.5 million at the Hilton Savannah DeSoto.

Room revenue on an aggregate basis for the year ended December 31, 2003 increased $0.2 million as compared to the year ended December 31, 2002. The Hilton Wilmington Riverside increased room revenue by $0.5 million despite losing $100,000 to Hurricane Isabel through group cancellations. Room revenue at the Hilton Savannah DeSoto declined $0.4 million due to a decision to pursue new business at a higher rate than groups and tour business.

ADR declined $0.38 or 0.4% from 2002 to 2003 while RevPAR increased approximately $0.71 or 1.1% from 2002 to 2003. Occupancy increased 1.0 occupancy percentage points during 2003 as compared to 2002.

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Operating Expenses. Total operating expenses increased by $0.4 million, or 2.0%, from $21.2 million in 2002 to $21.6 million in 2003. This increase was primarily due to higher energy costs of $0.1 million and higher food and beverage costs of $0.2 million. Food and beverage costs were driven by the increase of 4.9% in food and beverage business.

Depreciation and Amortization Expense. Depreciation and amortization expense decreased by approximately $191,000 or 8.5% for the year ended December 31, 2003 as compared to 2002 due to the absence of major capital expenditures.

Net Operating Income. Net operating income increased 1.7% in 2003. This increase is primarily due to lower depreciation and amortization costs offset by higher energy costs.

Interest Expense. Interest expense was essentially flat year over year ended December 31, 2003 declining approximately $112,000 from 2002 as favorable interest rates and declining principal balances decreased the interest expense. The Holiday Inn Downtown Williamsburg was refinanced in 2003, which had a positive effect on interest expense in 2004.

Net Income (Loss): In 2003, we posted a net gain of approximately $140,000 as compared to a net loss of approximately $122,000 in 2002.

MHI Hotel Services Group – Comparison of year ended December 31, 2002 to year ended December 31, 2001

Overview. The hotel business began slowing in the late spring of 2001. This soft market collapsed in the fall due to terrorist attacks in New York and Washington, D.C. Travel for the months of September through December particularly in the New York and Washington, D.C. areas, including Williamsburg, Virginia, was severely impacted. The year 2002 showed a mild

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rebound from these trends, but hotel business overall remained a soft market. Generally, a soft market is illustrated by stagnant growth overall. Opportunities for growth are limited and can be sector specific. Markets become soft when the economy, and travel, in particular, declines.

Revenues. Hotel operating revenue decreased by $150,000, or 0.6%. Increased revenues at the Hilton Savannah DeSoto were offset by declines at Hilton Wilmington Riverside and Holiday Inn Downtown Williamsburg.

Operating Expenses. Net hotel operating expenses were virtually unchanged for the two periods. Strict expense controls and wage and hiring freezes were put in effect after September 11, 2001. The net effect for the two periods was to hold expenses increase to approximately $13,000 increase, or 0.1%.

Depreciation and Amortization Expense. Depreciation and amortization expense increased by approximately $68,000.

Operating Income. Net operating income increased by approximately $163,000 from $2.9 million in 2001 to $2.8 million in 2002.

Interest Expense. Interest expense decreased from $2.6 million for the year ended December 31, 2001 to $2.5 million in 2002. This decrease was due to stable or declining interest rates combined with declining principal balances.

Net Income (Loss). In 2001, we posted a net loss of approximately $551,000, including approximately $192,000 of loss on disposal of assets. This compares to a net loss of approximately $122,000 in 2002.

Liquidity and Capital Resources

As of December 31, 2004, we had cash and cash equivalents of approximately $8.9 million which amount includes proceeds from our initial public offering and replacement reserve accounts. We intend to use the remaining proceeds from the initial public offering and the underwriters’ exercise of their over-allotment option to invest in additional hotel properties as suitable opportunities arise and to renovate three of our existing hotel properties.

Sources and Uses of Cash. Recurring capital expenditures and debt service are the most significant short-term liquidity requirements. During the next 12 months, we expect capital expenditures will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors, or as part of our upbranding strategy for the Best Western Maryland Inn. The capital reserve accounts are escrowed funds deposited monthly (5% of gross sales), and reserved for capital projects. The Hilton Savannah DeSoto and Hilton Wilmington Riverside have these reserve accounts. Our intent for the capital reserve accounts at other hotels is an overall blended rate of 4% of gross revenue.

In addition to our ongoing, recurring capital expenditures for our existing hotels, we are renovating three of our initial hotels. We intend to use approximately $7.9 million of the proceeds of the offering during fiscal 2005 to fund renovations and capital improvements at these hotels.

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In addition to recurring capital expenditures, renovations and debt service as uses of cash and requirements for short-term liquidity, we are required to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gain. We have declared a dividend of $0.17 per share payable on April 11, 2005 which we expect to fund out of working capital. See “Distributions to Stockholders.”

We expect to fund our short-term liquidity requirements, including working capital, through a combination of cash flows from operating activities and borrowings under a $23.0 million secured revolving line of credit that we entered into following the closing of our initial public offering. The credit facility has a term of three years and our borrowings under the credit facility are expected to bear interest at a floating interest rate of 30 day LIBOR plus 2.5%. The LIBOR rate on December 31, 2004 was 2.42. The primary collateral for the credit facility is a first mortgage on the Holiday Inn Brownstone and the Hilton Philadelphia Airport, and a lien on all business assets including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. We must satisfy certain financial and non-financial covenants. As of December 31, 2004, we are in compliance with all the required covenants. Failure to satisfy these covenants and conditions would create a default under this credit facility, and the lender could require us to immediately repay all outstanding indebtedness under the credit facility. The line has a balance of zero ($0.00) as of December 31, 2004. The Company intends to use the Line of Credit for capital acquisitions as deemed appropriate by the Directors of the Company.

Debt service requirements on our borrowings will reduce our cash flows. The initial public offering and the related repayment of indebtedness on certain of our initial properties, the restructuring of management agreements and our execution of a new management agreement with lower management fees will reduce historical debt service and management fee payments and, consequently, improve cash flow and liquidity. The new management fees positively impacted cash flow by approximately $2,000 for the eleven day period ended December 31, 2004.

Our long-term liquidity needs will generally include the funding of future acquisitions and development activity, the retirement of mortgage debt and amounts outstanding under our secured line of credit, and obligations under our tax indemnity agreements, if any. We remain committed to maintaining a flexible capital structure. Accordingly, in addition to the sources described above with respect to our short-term liquidity, we expect to meet our long-term liquidity needs through a combination of some or all of the following:

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In connection with the acquisition of our six initial hotel properties, we entered into tax indemnity agreements that require us to indemnify the contributors of our initial properties against tax liabilities in the event we sell those properties in a taxable transaction during a 10-year period. Such indemnification obligations could result in aggregate payments of approximately $46.0 million. Our obligations under the tax indemnity agreements may effectively preclude us from selling or disposing of certain of the initial hotels in taxable transactions or reducing our consolidated indebtedness below approximately $11.0 million.

We anticipate that our available cash and cash equivalents and cash flows from operating activities, with cash available from borrowings and other sources, will be adequate to meet our capital and liquidity needs in both the short and long term. However, if these sources of funds are insufficient or unavailable, our ability to satisfy cash payment obligations and make stockholder distributions may be adversely affected.

Outstanding Debt. After application of a portion of the net proceeds from the initial public offering to repay approximately $25.2 million of consolidated mortgage debt, we have approximately $25.8 million of outstanding debt. The following table sets forth the debt assumed by our operating partnership upon completion of our initial public offering.

Contractual Obligations. The following table outlines the timing of payment requirements related to the consolidated mortgage debt and other commitments of MHI Hotels Services Group as of December 31, 2004.

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Capital Expenditures

We do not expect our capital expenditures to exceed our reserves for such amounts, other than costs that we expect to incur to make capital improvements required by our franchisors or the capital improvements anticipated for the Best Western Maryland Inn which will be funded with the proceeds from the initial public offering.

In addition to the amounts disclosed above, we are subject to various franchise and management agreements that have ongoing fees that are contingent upon future results of operations of the hotels in our portfolio as well as a potential for termination fees dependent upon the timing and method of termination of such agreements.

Off Balance Sheet Arrangements. We currently have no off-balance sheet arrangements.

Distributions to Stockholders. We intend to elect to be taxed as a REIT commencing with our taxable year ending December 31, 2004. To qualify as a REIT, we will be required to make annual distributions to our stockholders of at least 90% of our REIT taxable income, (excluding net capital gain, which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). The amount, timing and frequency of distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future. Our ability to pay distributions to our stockholders will depend, in part, upon our receipt of distributions from our operating partnership which may depend upon receipt of lease payments with respect to our properties from our TRS Lessee, and in turn, upon the management of our properties by our hotel manager. Distributions to our stockholders will generally be taxable to our stockholders as ordinary income; however, because a portion of our investments will be equity ownership interests in hotels, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent not inconsistent with maintaining our REIT status, our TRS may retain any after-tax earnings.