Sotherly Hotels Inc. - Quarter Report: 2006 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2006

OR

For the transition period from              to             .

Commission file number 001-32379

MHI HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

814 Capitol Landing Road, Williamsburg, Virginia 23185

Telephone Number (757) 229-5648

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Large Accelerated Filer  ¨    Accelerated Filer  ¨    Non-accelerated Filer  x

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

As of August 8, 2006, there were 6,712,000 shares of the registrant’s common stock issued and outstanding.

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MHI HOSPITALITY CORPORATION

INDEX

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PART I

Item 1. Financial Statements

MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these financial statements.

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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

The accompanying notes are an integral part of these financial statements.

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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(unaudited)

The accompanying notes are an integral part of these financial statements.

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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

The accompanying notes are an integral part of these financial statements

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MHI HOSPITALITY CORPORATION

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Organization and Description of Business

MHI Hospitality Corporation (the “Company”) is a self-advised real estate investment trust (“REIT”) that was incorporated in Maryland on August 20, 2004 to own full-service upscale and mid-scale hotels located in primary and secondary markets in the mid-Atlantic and Southeastern regions of the United States. The hotels operate under well-known national hotel brands such as Hilton and Intercontinental Hotels Group brands. The Company commenced operations on December 21, 2004 when it completed its initial public offering (“IPO”) and thereafter consummated the acquisition of six hotel properties (“initial properties”). The Company utilized part of its net proceeds to repay approximately $25.0 million of mortgage indebtedness secured by the initial properties and paid an additional $16.9 million in cash related to the acquisition of the properties. Accordingly, the Company had approximately $12.9 million available in cash immediately following its formation.

On July 22, 2005, the Company acquired the Crowne Plaza Jacksonville Hotel (formerly, the Hilton Jacksonville Riverfront Hotel) in Jacksonville, Florida from BIT Holdings Seventeen, Inc., an affiliate of the AFL-CIO Building Investment Trust (the “Trust”), for an aggregate price of $22 million. The Trust, for which Mercantile Safe Deposit and Trust Company (“Mercantile”) acts as trustee, financed a portion of the purchase price by extending an $18 million mortgage loan (the “Loan”) to the purchaser. Pursuant to the terms of a Purchase Sale and Contribution Agreement dated May 20, 2005, MHI Hotels, LLC (“MHI Hotels”), an affiliate of MHI Hotels Services LLC (“MHI Hotels Services”), contributed furniture, fixtures and equipment used in the operation of the Hotel and assigned its leasehold interest and other rights relating to the property to the purchaser in exchange for 90,569 units in the operating partnership, MHI Hospitality L.P. (the “Operating Partnership”), valued at approximately $913,000. On April 1, 2006, the Company completed the re-flagging of the hotel to a Crowne Plaza.

On May 9, 2006, the Company closed on a senior secured revolving credit facility for up to $60 million which was syndicated by Branch Banking & Trust Company (“BB&T). The facility replaced an existing $23 million facility with BB&T and will be used to fund acquisitions and working capital.

On June 20, 2006, the Company announced it had entered into a definitive agreement to sell the Holiday Inn Downtown, in Williamsburg, VA for $4.75 million. The Company has agreed to take back three promissory notes that total $4.43 million from the purchaser and will receive the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007. The third promissory note in the amount of $0.4 million with interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. The Company has committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes will be secured by a security interest in the hotel and by personal guarantees of affiliates of the purchaser. The closing is subject to customary terms and conditions.

Substantially all of the Company’s assets are held by, and all of its operations are conducted through, the Operating Partnership. For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which is approximately 63.2% owned by the Company, leases its hotels to a subsidiary of MHI Hospitality TRS Holding Inc., MHI Hospitality TRS, LLC, (collectively, “MHI TRS”), a wholly owned subsidiary of the Operating Partnership. MHI TRS then engages a hotel management company to operate the hotels under a management contract. MHI TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

2. Summary of Significant Accounting Policies

Basis of Presentation – The consolidated financial statements of the Company presented herein include all of the accounts of MHI Hospitality Corporation as of and for the three months and six months ended June 30, 2006 and 2005.

Principles of Consolidation – The consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation.

Cash and Cash Equivalents – The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.

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Restricted Cash – Restricted cash includes real estate tax escrows and reserves for replacements of furniture, fixtures and equipment pursuant to certain requirements in the Company’s mortgage agreement with MMA Realty Capital, Inc. (“MMA”, formerly The Mutual of New York Life Insurance Company). MMA holds mortgages on the Hilton Wilmington Riverside and the Hilton Savannah DeSoto. In addition, restricted cash includes the unexpended balance of a capital improvement reserve account for the Crowne Plaza Jacksonville Hotel administered by Mercantile.

Fair Value of Financial Instruments – The Company’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and mortgage loans. Due to their short maturities, or in the case of mortgage loans, interest rates in line with current interest rates, these financial instruments are carried at amounts that reasonably approximate fair value.

Investment in Hotel Properties – Investments in hotel properties are recorded at acquisition cost and allocated to land, property and equipment and identifiable intangible assets in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation are removed from the Company’s accounts and any resulting gain or loss is included in the statements of operations. Expenditures under a renovation project, which constitute additions or improvements that extend the life of the property, are capitalized.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 15 to 39 years for buildings and building improvements and 3 to 10 years for furniture, fixtures and equipment. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the related assets.

The Company reviews its investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause a review include, but are not limited to, adverse changes in the demand for lodging at the properties due to declining national or local economic conditions and/or new hotel construction in markets where the hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations 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 amount to the related hotel property’s estimated fair market value is recorded and an impairment loss recognized.

Assets Held For Sale and Discontinued Operations – The Company records assets as held for sale when management has committed to a plan to sell the assets, actively seeks a buyer for the assets, and the consummation of the sale is considered probably and is expected within one year. The related operations of assets held for sale are reports as discontinued if 1) such operations and cash flows can be clearly distinguished, both operationally and financially, from the ongoing operations of the Company, 2) such operations and cash flows will be eliminated from ongoing operations once the disposal occurs, and 3) the Company will not have any significant continuing involvement subsequent to the disposal.

Franchise License Fees – Fees expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The unamortized franchise fees as of June 30, 2006 and December 31, 2005 were $197,120 and $208,308, respectively. Amortization expense totaled $7,513 and $14,592 for the three months and six months ended June 30, 2006 and $5,625 and $11,250 for the three and six months ended June 30, 2005, respectively.

Minority Interest in Operating Partnership – Certain hotel properties have been acquired, in part, by the Operating Partnership through the issuance of limited partnership units of the Operating Partnership. The minority interest in the Operating Partnership is: (i) increased or decreased by the limited partners’ pro-rata share of the Operating Partnership’s net income or net loss, respectively; (ii) decreased by distributions; (iii) decreased by redemption of partnership units for the Company’s common stock and (iv) adjusted to equal the net equity of the Operating Partnership multiplied by the limited partners’ ownership percentage immediately after each issuance of units of the Operating Partnership and/or the Company’s common stock through an adjustment to additional paid-in capital. Net income or net loss is allocated to the minority interest in the Operating Partnership based on the weighted average percentage ownership throughout the period.

Revenue Recognition – Revenues from operations of the hotels are recognized when the services are provided. Revenues consist of room sales, food and beverage sales, and other hotel department revenues, such as telephone, rooftop leases and gift shop sales and rentals.

Deferred Financing Costs – Deferred financing costs are recorded at cost and consist of loan fees and other costs incurred in issuing debt. Amortization of deferred financing costs is computed using a method that approximates the effective interest method over the term of the related debt and is included in interest expense in the statements of operations.

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Income Taxes – The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. As a REIT, the Company generally will not be subject to federal income tax on that portion of its net income (loss) that does not relate to MHI Hospitality TRS, LLC, the Company’s wholly owned taxable REIT subsidiary. MHI Hospitality TRS, LLC, which leases the Company’s hotels from the Operating Partnership, is subject to federal and state income taxes.

The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“SFAS 109”). Under SFAS 109, the Company accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

Stock-based Compensation – The Company’s 2004 Long Term Incentive Plan (“Plan”) permits the grant of stock options, restricted (non-vested) stock and performance share compensation awards to its employees for up to 350,000 shares of common stock. The Company believes that such awards better align the interest of its employees with those of its shareholders.

Under the Plan, the Company has made restricted stock and deferred stock awards totaling 81,000 shares including 69,000 shares granted under deferred stock awards to its executives, 4,000 restricted shares issued to certain employees, and 8,000 restricted shares issued to its directors. Of the 69,000 shares granted under deferred stock awards, 60,000 shares vest over five years and 9,000 shares vest at the end of this year. Regarding the restricted shares awarded the Company’s directors and certain employees; the shares vest immediately and represent compensation for the previous year of service. All such shares are charged to compensation expense on a straight-line basis over the vesting or service period based on the Company’s stock price on the date of grant or issuance. Under the Plan, the Company may issue a variety of performance-based stock awards, including nonqualified stock options. As of June 30, 2006, no performance-based stock awards have been issued. Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value method. Total compensation cost recognized under the Plan was $28,500 and $57,000 for the three months and six months ended June 30, 2006, respectively and $0 for the three months and six months ended June 30, 2005.

Comprehensive Income (Loss) – Comprehensive income (loss), as defined, includes all changes in equity (net assets) during a period from non-owner sources. The Company does not have any items of comprehensive income (loss) other than net income (loss).

Segment Information – Statement of Financial Accounting Standards No 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”), requires public entities to report certain information about operating segments. Based on the guidance provided in SFAS 131, the Company has determined that its business is conducted in one reportable segment, hotel ownership.

Use of Estimates – The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Reclassifications – Certain reclassifications have been made to the prior period balances to conform to the current period presentation.

3. Acquisition of Hotel Properties

There were no new acquisitions in the six months ended June 30, 2006.

4. Investment in Hotel Properties

Investment in hotel properties as of June 30, 2006 and December 31, 2005 consisted of the following (in thousands):

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5. Credit Facility

As of June 30, 2006, the Company had a secured, revolving credit facility with a financial institution that enabled the Company to borrow up to $60 million, subject to borrowing base and loan-to-value limitations, with a syndicated bank group comprising of Branch Banking & Trust Company (BB&T), Key Bank National Association, Regions Bank and Manufacturers and Traders Trust Company. The credit facility was refinanced during second quarter of 2006 and replaced a $23 million secured, revolving credit facility with BB&T. The Company had borrowings of $7,678,232 and $3,500,000 at June 30, 2006 and December 31, 2005, respectively.

The facility matures during May 2010 and bears interest at a floating rate of LIBOR plus additional interest ranging from 2.0% to 2.5%. On June 30, 2006, LIBOR was 5.334%. In some circumstances, the revolving line of credit facility may bear interest at BB&T’s prime rate. Any amounts drawn under the revolving line of credit facility mature at the expiration of the facility. The revolving line of credit facility includes an uncommitted accordion facility, pursuant to which the Company may be able to increase the total commitment under the revolving line of credit facility up to $75 million. The Company is required to pay a fee of 0.25% on the unused portion of the credit facility. Under the terms of the agreement, the Company is required to enter into an interest rate swap in order to hedge against interest rate risk.

The facility is secured by the Holiday Inn Brownstone and the Hilton Philadelphia Airport, and a lien on all business assets of those properties including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. The two properties had a net carrying value of approximately $35.6 million. Under the terms of the BB&T line of credit, the Company must satisfy certain financial and non-financial covenants. As of June 30, 2006 and December 31, 2005, the Company was in compliance with all of the required covenants.

6. Mortgage Debt

Upon its formation, the Company assumed existing mortgage debt with MMA Realty Capital, Inc. that was in place on two of the initial properties.

On September 25, 1998, Savannah Hotel Associates, LLC obtained a mortgage loan in the amount of $12.8 million to refinance the mortgage at the Savannah DeSoto Hilton hotel. The loan is secured by the Savannah DeSoto Hilton hotel and its maturity date is November 1, 2008. Loan principal and interest payments are due monthly, with fixed principal payments plus interest amortized over a twenty (20) year schedule. Interest is based on a fixed rate of 7.49%. Savannah Hotel Associates, LLC recorded deferred financing costs of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the loan as of June 30, 2006 and December 31, 2005 was $9,935,121 and $10,175,989, respectively.

On February 12, 1998 Capitol Hotel Associates, LP, LLP obtained a mortgage loan in the amount of $13.0 million to refinance the mortgage at the Wilmington Riverside Hilton hotel. On October 19, 1999 Capitol Hotel Associates, LP, LLP obtained a promissory note in the amount of $4.25 million upon completion of construction of renovations. The debt was consolidated into one instrument and is secured by the Wilmington Riverside Hilton hotel and its maturity date is March 1, 2008. Loan principal and interest payments are due monthly, with fixed principal payments and interest payments amortized over a twenty (20) year schedule. Interest is based on a fixed rate of 8.22%. Capitol Hotel Associates, LP, LLP recorded deferred financing costs of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the loan as of June 30, 2006 and December 31, 2005 was $14,222,512 and $14,510,954, respectively.

On July 22, 2005 the Company purchased the Crowne Plaza Jacksonville Hotel in Jacksonville, Florida from BIT Holdings Seventeen, Inc., an affiliate of the AFL-CIO Building Investment Trust (the “Trust”), for an aggregate price of $22 million. The Trust, for which Mercantile Safe Deposit and Trust Company (“Mercantile”) acts as trustee, financed a portion of the purchase price by extending an $18 million mortgage loan (the “Loan”) to the purchaser. The loan, which is secured by a lien against all the assets, rents and profits of the hotel as well as the real property, bears interest at the rate of 8.0% payable monthly during the term and matures in July 2010. Pre-payment penalties apply toward any principal of the loan repaid before the fifth year of the term.

Total debt maturities as of June 30, 2006 were as follows ($000s):

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7. Commitments and Contingencies

Ground, Building and Submerged Land Leases – The Company leases 2,086 square feet of commercial space next to the Savannah hotel property for use as an office, retail or conference space, or for any related or ancillary purposes for the hotel and/or atrium space. The space is leased under a six-year operating lease, which expires October 31, 2006. There is a renewal option for up to three five-year periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for this operating lease was $10,795 and $21,590 for the three months and six months ended June 30, 2006, respectively and $9,387 and $18,774 for the three months and six months ended June 30, 2005, respectively.

The Company leases, as landlord, the entire fourteenth floor of the Savannah hotel property to The Chatham Club, Inc. under a ninety-nine year lease expiring July 31, 2086. This lease was assumed upon the purchase of the building under the terms and conditions agreed to by the previous owner of the property. No rental income is recognized under the terms of this lease as the original lump sum rent payment of $990 was received by the previous owner and not prorated over the life of the lease.

The Company leases a parking lot adjacent to the Holiday Inn Brownstone in Raleigh, North Carolina. The land is leased under a second amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a 50-year operating lease, which expires August 31, 2016. There is a renewal option for up to three additional ten-year periods expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. The Company holds an exclusive and irrevocable option to purchase the leased land at fair market value at the end of the original lease term, subject to the payment of an annual fee of $9,000, and other conditions. Rent expense for this operating lease is $76,104 annually, and is expected to remain the same in 2006. For the three months ended June 30, 2006 and 2005, rent expense was $19,026. For the six months ended June 30, 2006 and 2005, rent expense was $38,052.

In conjunction with the sublease arrangement for the property at Shell Island, the Company incurs an annual lease expense for a leasehold interest other than the purchased leasehold interest. Lease expense was $40,238 and $80,213 for the three months and six months ended June 30, 2006 and $42,764 and $84,528 for the three months and six months ended June 30, 2005, respectively.

The Company leases certain submerged land in the Saint Johns River in front of the Crowne Plaza Jacksonville Hotel from the Board of Trustees of the Internal Improvement Trust Fund of the State of Florida. The submerged land is leased under a five-year operating lease, which expires September 18, 2007. Rent expense for the three months and six months ended June 30, 2006 was $1,160 and $2,320, respectively.

Purchase Agreement – On September 13, 2005, the Company entered into an agreement to purchase the commercial space of a property in Hollywood, Florida last operated as the Ambassador Resort for $0.5 million. The developer of the property is completing a condominium conversion after which time the Company will retain MHI Hotels Services to operate the hotel. Closing is contingent on a variety of factors including the Company’s ability to secure a franchise for the hotel.

Management Agreement – Each of the seven hotels that the Company owned at June 30, 2006 operate under a ten-year master management agreement with MHI Hotels Services which expires in December 2014 for the six initial hotels and in July 2015 for the Crowne Plaza Jacksonville Hotel (see Note 9).

Franchise Agreements – As of June 30, 2006, the Company’s seven hotels operate under franchise licenses from national hotel companies. Under the franchise agreements, the Company is required to pay a franchise fee generally between 2.5% and 5.0% of room revenues, plus additional fees that amount to between 2.5% and 6.0% of room revenues from the hotels.

Restricted Cash Reserves – The Company is required to escrow with its lender on the Wilmington Riverside Hilton and the Savannah DeSoto Hilton an amount equal to 1/12 of the annual real estate taxes due for the properties. The Company is also required to establish a property improvement fund for each of these two hotels to cover the cost of replacing capital assets at the properties. Contributions to the property improvement fund are based on a percentage of gross revenues or receipts at each hotel equating to 5%.

Litigation – The Company is not involved in any material litigation nor, to its knowledge, is any material litigation threatened against the Company.

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8. Capital Stock

Common Shares – The Company is authorized to issue up to 49,000,000 shares of common stock, $.01 par value per share. Each outstanding share of common stock entitles the holder to one vote on all matters submitted to a vote of stockholders. Holders of the Company’s common stock are entitled to receive distributions when authorized by the Company’s board of directors out of assets legally available for the payment of distributions.

On December 21, 2004, the Company completed its IPO and sold 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 December 21, 2004 the Company issued 4,000 shares of common stock to its independent directors. 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 underwriters’ over-allotment option, resulting in additional net proceeds of approximately $6.5 million. The total net proceeds generated from the IPO and the underwriters’ over-allotment was approximately $61.3 million. In June 2006, the Company issued 8,000 shares of restricted common stock to its independent directors and non-executive employees. As of June 30, 2006, the Company had 6,712,000 shares of common stock outstanding.

Warrants – The Company has granted no warrants representing the right to purchase common stock.

Preferred Shares – The Company is authorized to issue 1,000,000 shares of preferred stock, $.01 par value per share. As of June 30, 2006, there were no shares of preferred stock outstanding.

Operating Partnership Units – 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 the Company’s common stock on a one-for-one basis or, at the option of the Company, cash per unit equal to the market price of the Company’s 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 the stockholders of the Company. As of June 30, 2006, the total number of Operating Partnership units outstanding was 3,907,607.

9. Related Party Transactions

The following is a summary of the transactions between the Company and MHI Hotels Services:

Accounts Receivable – At June 30, 2006 and December 31, 2005, the Company was due $4,463 and $242,362, respectively, from MHI Hotels Services.

Shell Island Sublease – The Company has a sublease arrangement with MHI Hotels Services on its leasehold interests in the property at Shell Island. For the three months ended June 30, 2006 and 2005, the Company earned $160,000 in leasehold revenue. For the six months ended June 30, 2006 and 2005, the Company earned $320,000 in leasehold revenue.

Sublease of Office Space – The Company subleases office space in Greenbelt, MD from MHI Hotels Services. Rent expense was $9,270 and $18,540 for the three months and six months ended June 30, 2006, respectively and $11,930 and $6,375 for the three months and six months ended June 30, 2005, respectively.

Strategic Alliance Agreement – On December 21, 2004, the Company entered into a ten-year strategic alliance agreement with MHI Hotels Services that provides in part for the referral of acquisition opportunities to the Company and the management of its hotels by MHI Hotels Services.

Management Agreements – Each of the seven hotels that the Company owned at June 30, 2006 are operated by MHI Hotels Services under a master management agreement which expires in December 2014 for the six initial hotels and in July 2015 for the Crowne Plaza Jacksonville Hotel. MHI Hotels Services receives a base management fee, and if the hotels meet and exceed certain thresholds, an additional incentive management fee. The base management fee for the initial portfolio of six hotels was 2.0% in 2005, rising to 2.5% in 2006 and 3.0% thereafter of total gross revenues from the hotels. The base management fee for the Crowne Plaza Jacksonville Hotel is 2.0% through 2006, rising to 2.5% in 2007 and 3.0% thereafter. 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 management fee may not exceed 0.25% of gross revenues of all of the hotels included in the incentive fee calculation. Due to the uncertainty related to the calculation of the incentive management fees, the Company has not accrued any related expense related to these fees as of June 30, 2006.

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The Company paid MHI Hotels Services approximately $0.469 million and $0.844 million for the three months and six months ended June 30, 2006, respectively, and approximately $0.227 million and $0.527 million for the three months and six months ended June 30, 2005, respectively, in management fees.

Employee Medical Benefits – The Company purchases employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. The Company paid $18,708 and $36,093 for the three months and six months ended June 30, 2006, respectively and $7,125 and $14,250 for the three months and six months ended June 30, 2005, respectively for benefits.

Reimbursement of Real Estate and Personal Property Taxes – In January 2006, the Company received reimbursement of real estate and personal property taxes totaling $173,632 related to the acquisition of the Crowne Plaza Jacksonville. The reimbursement for accrued taxes due at settlement was deferred until receipt and payment of the annual tax invoices.

Construction Management Services – The Company engaged MHI Hotels Services to manage the renovation of the Crowne Plaza Jacksonville. For the three months and six months ended June 30, 2006, the company paid $112,000 in construction management fees.

10. Income Taxes

The components of the income tax provision (benefit) for the three months and six months ended June 30, 2006 and 2005 are as follows (in thousands):

A reconciliation of the statutory federal income tax expense to the Company’s income tax provision is as follows (in thousands):

As of June 30, 2006, the Company had a net deferred tax asset of approximately $0.84 million, primarily due to past years’ net operating loss. These loss carryforwards will begin to expire in 2024 if not utilized by then. The Company believes that is more likely than not that the deferred tax asset will be realized and that no valuation allowance is required.

11. Discontinued Operations

The provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, require that hotels sold or held for sale be treated as discontinued operations.

On June 20, 2006, the Company announced it had entered into a definitive agreement to sell the Holiday Inn Downtown, in Williamsburg, VA. The results of operations of the property for the three months and six months ended June 30, 2006 and 2005 have been classified or reclassified as discontinued operations. After transaction costs, the Company does not expect to recognize any material gain or loss on sale of the property.

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The results of operations for the property for the three months and six months ended June 30, 2006 and 2005 were as follows:

12. Earnings per Share

Diluted net income per share takes into consideration the pro forma dilution of certain unvested stock awards.

13. Subsequent Events

On July 6, 2006, the Company announced that it entered into a definitive agreement to purchase the 186-room Louisville Ramada Riverfront Inn, located in Jeffersonville, Indiana for $7.6 million. The hotel is located directly on the Ohio River, with unimpeded views of the Louisville skyline, and easy access to the center of downtown Louisville. The Company intends to extensively renovate and re-brand the hotel, as is consistent with the company’s repositioning strategy. To facilitate the closing of the acquisition, which is expected in the late third quarter subject to customary closing conditions, the Company may access funds from either its line of credit or the proceeds of the sale of the Holiday Inn Downtown Williamsburg, VA, or a combination of the two.

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On July 11, 2006, the Company paid the dividend for the second quarter of 2006 that was authorized on April 24, 2006 to those stockholders and unit holders of MHI Hospitality, L.P. of record on June 15, 2006. The dividend was $0.17 per share (unit).

On July 17, 2006, the Company authorized the payment of a quarterly dividend of $0.17 per share (unit) to the stockholders and unit holders of record as of September 15, 2006. The dividend is to be paid October 11, 2006.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a self-advised REIT incorporated in Maryland in August 2004 to pursue current and future opportunities in the full-service, upper upscale, upscale and mid-scale segments of the hotel industry. We commenced operations in December 2004 when we completed our initial public offering.

Concurrent with the completion of the IPO, we acquired six hotel properties. Our hotel portfolio currently consists of seven full-service, upper upscale and mid-scale hotels. The seventh hotel, the Crowne Plaza Jacksonville Hotel (formerly, the Hilton Jacksonville Riverfront Hotel), was acquired on July 22, 2005. We own a 100% interest in all of our hotels. We also have a leasehold interest in a resort condominium facility. As of June 30, 2006, we owned the following hotel properties:

On June 15, 2006, we entered into a definitive agreement to sell the Holiday Inn Downtown, in Williamsburg, VA for $4.75 million. We agreed to take back three promissory notes totaling $4.43 million from the purchaser and will receive the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007. The third note in the amount of $0.4 million with interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. We have committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes will be secured by a security interest in the hotel and by personal guarantees of affiliates of the purchaser. The closing is subject to customary terms and conditions.We conduct substantially all 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 63.2% interest in our operating partnership, with the remaining interest being held by the contributors of our initial properties as limited partners.

To qualify as a REIT, we cannot operate hotels. Therefore, our operating partnership leases our hotel properties to MHI Hospitality TRS, LLC, our TRS Lessee. Our TRS Lessee has engaged MHI Hotels Services, LLC (“MHI Hotels 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.

Key Operating Metrics

In the hotel industry, most categories of operating costs, with the exception of franchise, management, credit card fees and the costs of the food and beverage 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, beverage and telephone. There are three key performance indicators used in the hotel industry to measure room revenues:

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Results of Operations

The following table illustrates the key operating metrics for the three months and six months ended June 30, 2006 and 2005 for the properties owned by the Company during the respective reporting periods. Accordingly, the operations of the Crowne Plaza Jacksonville Hotel are not reflected for the three months and six months ended June 30, 2005.

In addition, the table below illustrates the same metrics as they pertain to all seven properties in our current portfolio for both periods. The 2005 figures reflect the performance of the Crowne Plaza Jacksonville under previous ownership. That hotel was managed by MHI Hotels Services throughout 2005.

Comparison of Three Months Ended June 30, 2006 to Three Months Ended June 30, 2005

Revenue. Total revenue for the three months ended June 30, 2006 was approximately $18.6 million, an increase of approximately $4.3 million or 30.0% from the three months ended June 30, 2005. Approximately $2.8 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.2 million as a result of increases in occupancy and ADR.

Room revenues for the three months ended June 30, 2006 rose to approximately $12.4 million, an increase of approximately $2.9 million or 30.7% compared to room revenues for the three months ended June 30, 2005. Approximately $1.7 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.2 million or 12.2%. A new mix of business, a strong market, and the completion of room renovations caused a significant increase in ADR at our Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also contributed to the significant increase in ADR at that property.

Overall, our seven properties were able to achieve a 6.7% increase in room revenue through a combined 0.9% increase in occupancy and a 5.7% increase in ADR over the same period last year.

Food and beverage revenues for the three months ended June 30, 2006 increased approximately $1.1 million or 26.7% to approximately $5.4 million compared to food and beverage revenues for the three months ended June 30, 2005. Approximately $0.9 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees were approximately $13.6 million, an increase of approximately $3.5 million or 34.5% for the three months ended June 30, 2006 compared to approximately $10.1 million for the three months ended June 30, 2005, of which approximately $2.4 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005.

Rooms expense for the three months ended June 30, 2006 increased approximately $1.0 million or 40.7% to approximately $3.4 million compared to rooms expense of approximately $2.4 million for the three months ended June 30,

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2005. Approximately $0.6 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Much of the remaining increase relates to increased expenses at our Hilton brand properties for replacing room amenities as well as the increased cost of implementing the Hilton bedding program.

Food and beverage expenses for the three months ended June 30, 2006 increased approximately $0.8 million or 29.6% to approximately $3.5 million compared to food and beverage expense for the three months ended June 30, 2005. The higher food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the three months ended June 30, 2006 increased approximately $1.7 million or 34.6% to approximately $6.5 million compared to the three months ended June 30, 2005, of which approximately $1.2 million was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Some of the indirect expenses vary directly with increases in revenue. Accordingly, we saw significant increases in sales and marketing expenses, hotel franchising fees and management fees.

Depreciation and amortization. Depreciation and amortization expense for the three months ended June 30, 2006 was approximately $1.2 million, an increase of approximately $0.2 million or 15.5% compared to approximately $1.0 million for the three months ended June 30, 2005. The increase in depreciation and amortization was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended June 30, 2006 increased approximately $0.2 million or 33.6% compared to approximately $0.7 million for the three months ended June 30, 2005. Increased staffing levels including the hiring of our Chief Operating Officer in January 2006 and our Chief Accounting Officer in May 2005 contributed to the increase.

Interest Expense. Interest expense for the three months ended June 30, 2006 increased approximately $0.7 million or 159.5% to approximately $1.1 million compared to interest expense for the thee months ended June 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of credit.

Income Tax Provision. The net income tax provision for the three months ended June 30, 2006 increased to approximately $0.3 million. The income tax provision is primarily derived from the taxable income of our TRS lessee. The taxable income of our TRS lessee attributable to continuing operations for the three months ended June 30, 2006 was greater than the taxable income attributable to continuing operations for the three months ended June 30, 2005.

Net income. The net income for the three months ended June 30, 2006 decreased approximately $0.3 million compared to the three months ended June 30, 2005 as a result of the operating results discussed above.

Comparison of Six Months Ended June 30, 2006 to Six Months Ended June 30, 2005

Revenue. Total revenue for the six months ended June 30, 2006 was approximately $34.1 million, an increase of approximately $8.7 million or 34.4% from the six months ended June 30, 2005. The increase was primarily due to approximately $6.4 million in incremental revenues attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Revenues increased due to increases in both room revenue and food and beverage revenues. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.8 million as a result of an increase in ADR.

Room revenues for the six months ended June 30, 2006 rose to approximately $22.8 million, an increase of approximately $6.0 million or 35.3% compared to room revenues for the six months ended June 30, 2005. Approximately $4.2 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increase approximately $1.8 million or 10.6%. A new mix of business, a strong market, and the completion of room renovations caused a significant increase in ADR at our Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also contributed to the significant increase in ADR at that property.

Overall, our seven properties were able to achieve a 5.6% increase in revenue despite a 2.1% decline in occupancy by achieving a 7.9% increase in ADR over the same period.

Food and beverage revenues for the six months ended June 30, 2006 increased approximately $2.2 million or 29.0% to approximately $9.6 million compared to food and beverage revenues for the six months ended June 30, 2005. Approximately $1.7 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees were approximately $25.9 million, an increase of approximately $6.6 million or

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34.6% for the six months ended June 30, 2006 compared to approximately $19.3 million for the six months ended June 30, 2005, primarily due to approximately $5.2 million in incremental expense attributable to the acquisition of the Crowne Plaza Jacksonville Hotel in July 2005.

Rooms expense for the six months ended June 30, 2006 increased approximately $1.7 million or 37.4% to approximately $6.3 million compared to rooms expense of approximately $4.6 million for the six months ended June 30, 2005 primarily due to the acquisition of the Crowne Plaza Jacksonville Hotel. Much of the remaining increase relates to increased expenses at our Hilton brand properties for replacing room amenities as well as the increased cost of implementing the Hilton bedding program.

Food and beverage expenses for the six months ended June 30, 2006 increased approximately $1.5 million or 30.6% to approximately $6.6 million compared to food and beverage expense for the six months ended June 30, 2005. The higher food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the six months ended June 30, 2006 increased approximately $3.2 million or 34.7% to approximately $12.6 million compared to the six months ended June 30, 2005, primarily due to the acquisition of the Crowne Plaza Jacksonville Hotel. We saw significant increases in sales and marketing expenses, hotel franchise fees and management fees as these expenses vary directly with increases in revenue.

Depreciation and amortization. Depreciation and amortization expense for the six months ended June 30, 2006 was approximately $2.4 million, an increase of approximately $0.5 million or 29.7% compared to approximately $1.8 million for the six months ended June 30, 2005. The increase in depreciation and amortization was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel as well as the renovation activities at our Philadelphia, Williamsburg and Laurel properties.

Corporate General and Administrative. Corporate general and administrative expenses for the six months ended June 30, 2006 increased approximately $0.5 million or 50.7% compared to the six months ended June 30, 2005 to approximately $1.5 million. Increased staffing levels, including the hiring of our Chief Operating Officer in January 2006 and our Chief Accounting Officer in May 2005, as well as an accelerated timetable for the preparation of the Company’s tax returns contributed to the increase.

Interest Expense. Interest expense for the six months ended June 30, 2006 increased approximately $1.0 million or 99.9% to approximately $2.1 million compared to interest expense for the same period ended June 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of credit.

Income Tax Provision. The net income tax provision for the six months ended June 30, 2006 increased to approximately $0.2 million. The income tax provison is primarily derived from the taxable income of our TRS lessee. The taxable income of our TRS lessee attributable to continuing operations for the six months ended June 30, 2006 was greater than the taxable income attributable to continuing operations for the six months ended June 30, 2005.

Net income. The net income for the six months ended June 30, 2006 decreased approximately $0.1 million compared to the six months ended June 30, 2005 as a result of the operating results discussed above.

Funds From Operations

Funds from Operations, FFO, is used by industry analysts and investors as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts, NAREIT. FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any minority interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by itself. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from GAAP net income.

Management believes that the use of FFO, combined with the required GAAP presentations, has improved the understanding of the operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure of adjusted net income for reviewing comparative operating and financial performance because we believe FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the

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operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.

The following table reconciles net income to FFO for the three months and six months ended June 30, 2006 and 2005 (unaudited):