Sotherly Hotels Inc. - Quarter Report: 2011 March (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 March 31, 2011

OR

For the transition period from to              to             .

Commission file number 001-32379

MHI HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

410 W. Francis Street, 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)    Yes  ¨    No  ¨

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

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

As of May 4, 2011, there were 9,586,786 shares of the registrant’s common stock issued and outstanding.

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MHI HOSPITALITY CORPORATION

INDEX

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PART I

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 CHANGES IN 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-managed and self-administered real estate investment trust (“REIT”) that was incorporated in Maryland on August 20, 2004 to own primarily full-service upper-upscale and upscale hotels located in primary and secondary markets in the Mid-Atlantic and Southern United States. The hotels operate under well-known national hotel brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn.

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 (the “initial properties”). Substantially all of the Company’s assets are held by, and all of its operations are conducted through, MHI Hospitality, L.P. (the “Operating Partnership”). The Company also owns a 25.0% non-controlling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with CRP/MHI Holdings, LLC, an affiliate of both Carlyle Realty Partners V, L.P. and The Carlyle Group (“Carlyle”).

For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which, at March 31, 2011, was approximately 74.1% 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, MHI Hotels Services, LLC (“MHI Hotels Services”), to operate the hotels under a management contract. MHI TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

Significant transactions occurring during the current and prior fiscal year include the following:

On June 4, 2010, the Company entered into a fifth amendment to its credit agreement to address the sufficiency of the borrowing base. The amendment revises the methodology used to value the Company’s existing hotel properties in the borrowing base and modifies certain other aspects of the credit agreement, as amended, including fixing the interest rate spread for the variable LIBOR-based interest rate at 4.00% and a minimum LIBOR of 0.75%. The amendment converts the facility to non-revolving, eliminates the Company’s ability to re-borrow principal paid in the future and establishes minimum repayments equal to 50% of excess cash flow, as defined in the agreement, payable quarterly. Pursuant to the amendment, the Company is required to fund reserves for insurance and real estate taxes as well as a reserve for the replacement of furniture, fixtures and equipment equal to 3.0% of gross room revenues. The amendment also modifies the fixed charge covenant, eliminates the leverage covenant, places limits on capital expenditures and requires prepayments from a portion of the proceeds of future equity offerings of up to $21.7 million. In the event that the Company makes prepayments totaling $21.7 million, the excess cash flow prepayment requirement will terminate. The amendment allows the Company to pay additional dividends in any fiscal quarter, subject to the existing cap of 90% of the prior year’s funds from operations (“FFO”) provided certain liquidity thresholds and other conditions are met. The amendment provides for a contingent extension of the maturity date for one year to May 2012, provided that certain valuation and other criteria are met, including payment of an extension fee and an extension or refinancing of the Jacksonville mortgage.

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, the Operating Partnership, MHI TRS and subsidiaries as of March 31, 2011 and December 31, 2010 and for the three month periods ended March 31, 2011 and 2010. All significant inter-company balances and transactions have been eliminated.

Investment in Hotel Properties – Investments in hotel properties include investments in operating properties which are recorded at acquisition cost and allocated to land, property and equipment and identifiable intangible assets. 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 7 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

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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.

Investment in Joint Venture – Investment in joint venture represents the Company’s non-controlling indirect 25.0% equity interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel under a management contract; (iii) the entity that entered into a lease agreement upon closing of the hotel acquisition with respect to the adjacent three-acre site on which is located a parking garage that is utilized by the hotel; and (iv) the entity that owned the junior participation in the existing mortgage. Carlyle owns a 75.0% controlling indirect interest in all these entities. The Company accounts for its investment in the joint venture under the equity method of accounting and is entitled to receive its pro rata share of annual cash flow. The Company also has the opportunity to earn an incentive participation in net sale proceeds based upon the achievement of certain overall investment returns, in addition to its pro rata share of net sale proceeds.

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

Concentration of Credit Risk – The Company holds cash accounts at several institutions in excess of the FDIC protection limits of $250,000. The Company’s exposure to credit loss in the event of the failure of these institutions is represented by the difference between the FDIC protection limit and the total amounts on deposit. Management monitors, on a regular basis, the financial condition of the financial institutions along with the balances there on deposit to minimize the Company’s potential risk.

Restricted Cash – Restricted cash includes real estate tax escrows, insurance escrows and reserves for replacements of furniture, fixtures and equipment pursuant to certain requirements in the Company’s various mortgage agreements and line of credit.

Inventories – Inventories which consist primarily of food and beverage are stated at the lower of cost or market, with cost determined on a method that approximates first-in, first-out basis.

Franchise License Fees – Fees expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The un-amortized franchise fees as of March 31, 2011 and December 31, 2010 were $319,415 and $331,002, respectively. Amortization expense for the three months ended March 31, 2011 and 2010 totaled $11,587 and $12,187, respectively.

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 consolidated statements of operations.

Derivative Instruments – The Company’s derivative instruments are reflected as assets or liabilities on the balance sheet and measured at fair value. Derivative instruments used to hedge the exposure to changes in the fair value of an asset, liability or firm commitment attributable to a particular risk, such as an interest rate risk, are considered fair value hedges. Derivative instruments used to hedge exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. For a derivative instrument designated as a cash flow hedge, the change in fair value each period is reported in accumulated other comprehensive income in stockholders’ equity to the extent the hedge is effective. For a derivative instrument designated as a fair value hedge, the change in fair value each period is reported in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. For a derivative instrument that does not qualify for hedge accounting or is not designated as a hedge, the change in fair value each period is reported in earnings.

The Company’s objective in using derivatives is to add stability to interest expense and to manage its exposure to interest-rate movements. To accomplish this objective, the Company primarily uses an interest-rate swap as part of its interest-rate risk management strategy. The interest-rate swap is required under its credit agreement and acts as a cash flow hedge involving the receipts of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreement without exchange of the underlying $30.0 million principal amount. During the three months ended March 31, 2011 and 2010, such derivatives were used to hedge the variable cash flows associated with the credit facility. The Company does not enter into derivative instruments for speculative trading purposes.

At March 31, 2011 and December 31, 2010, the interest-rate swap agreement had an estimated fair value of $(22,612) and $(72,649), respectively, and is included in accounts payable and other accrued liabilities.

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The Company values its interest-rate swap at fair value, which it defines as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company classifies the inputs used to measure fair value into the following hierarchy:

The Company endeavors to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Company’s interest-rate swap liability is valued by discounting expected future cash flows based on quoted prices for forward interest-rate contracts. As such, these derivative instruments are classified within level 2.

Noncontrolling 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 noncontrolling 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 noncontrolling 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, parking, gift shop sales, and rentals from restaurant tenants, rooftop leases and gift shop operators.

Occupancy and Other Taxes – Revenues are reported net of occupancy and other taxes collected from customers and remitted to governmental authorities.

Income Taxes – The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, the Company generally will not be subject to federal income tax on that portion of its net income 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 subsidiaries of the Operating Partnership, is subject to federal and state income taxes.

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. As of March 31, 2011, the Company has no uncertain tax positions. In addition, the Company recognizes obligations for interest and penalties related to uncertain tax positions, if any, as income tax expense. The period from December 21, 2004 through December 31, 2010 remains open to examination by the major taxing jurisdictions to which the Company is subject.

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

Under the Plan, the Company has made restricted stock and deferred stock awards totaling 215,938 shares including 171,938 shares issued to certain executives and employees, and 44,000 restricted shares issued to its directors. Of the 171,938 shares issued to certain of the Company’s executives and employees, all have vested except 21,000 shares issued to the Vice President and General Counsel upon execution of his employment contract which will vest in equal amounts of 7,000 shares on each anniversary of the effective date of his employment agreement over a three-year period. Regarding the restricted shares awarded to the Company’s directors, all of the shares have vested except 12,000 shares which vest at the end of 2011.

The value of the awards is 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 March 31, 2011, no performance-based stock awards have been granted. Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value

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method. Compensation cost recognized under the Plan for the three months ended March 31, 2011 and 2010 totaled $13,168 and $42,428, respectively.

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 – 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.

Recent Accounting Pronouncements – There are no recent accounting pronouncements which the Company believes will have a material impact on its financial statements.

3. Acquisition of Hotel Properties

There were no new acquisitions during the three months ended March 31, 2011.

4. Investment in Hotel Properties

Investment in hotel properties as of March 31, 2011 and December 31, 2010 consisted of the following (in thousands):

5. Debt

Credit Facility. As of March 31, 2011, the Company had a secured credit facility with a syndicated bank group comprised of BB&T, Key Bank National Association and Manufacturers and Traders Trust Company. The credit facility was established during the second quarter of 2006 and replaced a $23.0 million secured, revolving credit facility with BB&T.

On August 1, 2007, the Company entered into an amendment to its credit agreement modifying certain provisions of the agreement as well as reducing the rate of interest on the credit facility by 0.375% and extending the maturity date by one year. On April 15, 2008, the Company entered into a second amendment to its credit agreement modifying certain provisions of the agreement including increases in the lenders’ revolver commitments by $20.0 million, thereby enabling the Company to borrow up to $80.0 million. On February 19, 2009, the Company entered into a third amendment to its credit agreement modifying certain provisions of the agreement as well as increasing the rate of interest on the credit facility by 1.125%. On June 4, 2010, the Company entered into a fifth amendment to its credit agreement modifying certain provisions of the agreement including an increase in the rate of interest to LIBOR plus additional interest of 4.00%; a LIBOR floor of 0.75%; a conversion to a non-revolving facility; a provision for mandatory quarterly pre-payments based on excess cash flow, as defined in the amendment, as well as a mandatory prepayment if the Company raises equity within certain parameters; and provides an option to extend the maturity for one year if certain conditions are met. The Company had borrowings under the credit facility of approximately $75.2 million at both March 31, 2011 and December 31, 2010.

Prior to entering into a sixth amendment to the credit agreement (see Note 13), the credit facility was set to mature in May 2011 and bore interest at a floating rate of LIBOR plus additional interest ranging from 2.75% to 3.25% prior to June 4, 2010 after which the facility bore interest at a floating rate of LIBOR plus additional interest of 4.00%, subject to a LIBOR floor of 0.75%. On March 31, 2011, LIBOR was 0.243%. Prior to June 4, 2010, the Company was 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 maintain an interest rate swap in order to hedge against interest rate risk.

The credit facility is secured by the Holiday Inn Brownstone in Raleigh, North Carolina, the Hilton Philadelphia Airport, the Sheraton Louisville Riverside, the Holiday Inn Laurel West and the Crowne Plaza Tampa Westshore, as well as a lien on all business

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assets of those properties including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. At March 31, 2011, the five properties had a net carrying value of approximately $101.9 million. Under the terms of the credit agreement, the Company must satisfy certain financial and non-financial covenants. The Company was in compliance with all required covenants as of March 31, 2011.

Mortgage Debt. As of March 31, 2011, the Company had approximately $72.0 million of outstanding mortgage debt. The following table sets forth the Company’s mortgage debt obligations on its hotels.

Total mortgage debt maturities as of March 31, 2011 without respect to any additional loan extensions for the following twelve-month periods were as follows:

Other Loans. On February 9, 2009, the indirect subsidiary of the Company which is a member of the joint venture entity that owns the Crowne Plaza Hollywood Beach Resort, borrowed $4.75 million from the Carlyle Affiliate Lender for the purpose of improving the Company’s liquidity. In June 2008, the joint venture that owns the property purchased a junior participation in a portion of the mortgage loan from the lender. The amount of the loan from the Carlyle Affiliate Lender approximated the amount the Company contributed to the joint venture to enable the joint venture to purchase its interest in the mortgage loan. The interest rate and maturity date of the loan are tied to a note that is secured by a mortgage on the property. The loan, which currently bears a rate of LIBOR plus additional interest of 3.00%, requires monthly payments of interest and principal equal to 50.0% of any distributions it receives from the joint venture. The maturity date of the mortgage to which the loan is tied matures in August 2014. The outstanding balance on the loan at both March 31, 2011 and December 31, 2010 was $4,493,970.

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6. 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. In December 2007, the Company signed an amendment to the lease to include rights to the outdoor esplanade adjacent to the leased commercial space. These areas are leased under a six-year operating lease, which expired October 31, 2006 and has been renewed for the first of three optional five-year periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for the three months ended March 31, 2011 and 2010 totaled $17,216 and $15,387, respectively, for this operating lease.

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 each of the three months ended March 31, 2011 and 2010 totaled $23,871.

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 totaled $58,750 for each of the three months ended March 31, 2011 and 2010.

The Company leases a parking lot in close proximity to the Sheraton Louisville Riverside. The land is leased under an agreement dated August 17, 2007 with the City of Jeffersonville, which in turn leases the property from the State of Indiana. The lease term for the parking lot coincides with that of the lease with the State of Indiana, which expires December 31, 2011. The Company has the right to renew or extend the lease with the City of Jeffersonville pursuant to the conditions of the original lease provided that the City of Jeffersonville is able to renew or extend the underlying lease with the State of Indiana. Rent expense totaled $8,400 for each of the three months ended March 31, 2011 and 2010.

The Company leases a parking lot adjacent to the Crowne Plaza Tampa Westshore under a five-year agreement with the Florida Department of Transportation that commenced in July 2009 and expires in July 2014. The agreement requires annual payments of $2,432, plus tax, and may be renewed for an additional five years. Rent expense totaled $689 and $608 for the three months ended March 31, 2011 and 2010, 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, 2012 requiring annual payments of $4,961. Rent expense totaled $1,240 for each of the three months ended March 31, 2011 and 2010.

The Company leases 3,542 square feet of commercial office space in Williamsburg, Virginia under an agreement that commenced September 1, 2009 and expires August 31, 2015. Rent expense totaled $13,750 for each of the three months ended March 31, 2011 and 2010.

The Company leases 1,632 square feet of commercial office space in Rockville, Maryland under an agreement that commenced December 14, 2009 and expires February 28, 2017. The agreement requires monthly payments at an annual rate of $22,848 for the first year of the lease term and monthly payments at an annual rate of $45,696 for the second year of the lease term, increasing 2.75% per year for the remainder of the lease term. Rent expense for the three months ended March 31, 2011 and 2010 was $11,183 and $11,013, respectively.

The Company also leases certain furniture and equipment under financing arrangements expiring between October 2011 and March 2014.

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A schedule of minimum future lease payments for the following twelve-month periods is as follows:

Management Agreements – Each of the operating hotels that the Company wholly-owned at March 31, 2011, except for the Crowne Plaza Tampa Westshore, are operated by MHI Hotels Services under a master management agreement that expires between December 2014 and April 2018. The Company entered into a separate management agreement with MHI Hotels Services for the management of the Crowne Plaza Tampa Westshore that expires in March 2019 (see Note 8).

Franchise Agreements – As of March 31, 2011, the Company’s 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. The franchise agreements currently expire between November 2011 and April 2023.

Restricted Cash Reserves – Each month, 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. Each month, contributions to the property improvement fund equal 4.0% of gross revenues for the Hilton Savannah DeSoto and the Hilton Wilmington Riverside.

Pursuant to the terms of the mortgage on the Crowne Plaza Jacksonville Riverfront, the Company is required to make monthly contributions equal to 4.0% of room revenues into a property improvement fund.

Pursuant to the terms of the mortgage on the Crowne Plaza Hampton Marina, the Company is required to make monthly contributions equal to 4.0% of gross revenues to a property improvement fund.

Pursuant to the terms of the fifth amendment to the credit agreement, the Company is required to escrow with its lender an amount sufficient to pay the real estate taxes as well as property and liability insurance for the encumbered properties when due. In addition, the Company is required to make monthly contributions equal to 3.0% of room revenues into a property improvement fund.

Litigation – The Company is not involved in any material litigation, nor, to its knowledge, is any material litigation threatened against the Company. The Company is involved in routine legal proceedings arising out of the ordinary course of business, all of which the Company expects to be covered by insurance. The Company does not expect any pending legal proceedings to have a material impact on its financial condition or results of operations.

7. Capital Stock

Common Shares – The Company is authorized to issue up to 49,000,000 shares of common stock, $0.01 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 March 22, 2011, the Company issued 17,500 shares of non-restricted stock to certain executives and employees as well as 12,000 shares of restricted stock to its then serving independent directors.

On January 25, 2011, the Company issued 16,000 non-restricted shares to its Chief Operating Officer and President in accordance with the terms of his employment contract, as amended.

On June 7, 2010, the Company issued 21,000 shares of restricted stock to its Vice President and General Counsel in accordance with the terms of his employment contract.

On March 22, 2010, one holder of units in the Operating Partnership redeemed 368,168 units for an equivalent number of shares of the Company’s common stock.

During February 2010, the Company issued 18,175 shares of non-restricted stock to certain executives and 12,000 shares of restricted stock to its independent directors.

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In addition, on February 1, 2010, the Company issued 15,000 shares of non-restricted stock to its Chief Executive Officer in accordance with the terms of his renewed employment contract.

As of March 31, 2011 and December 31, 2010, the Company had 9,586,786 and 9,541,286 shares of common stock outstanding, respectively.

Warrants – As of March 31, 2011, 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 March 31, 2011, 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 March 31, 2011, the total number of Operating Partnership units outstanding was 3,354,439, with a fair market value of approximately $8.5 million based on the price per share of the common stock on that date.

8. Related Party Transactions

As of March 31, 2011, the members of MHI Hotels Services (a company that is majority-owned and controlled by the Company’s chief executive officer, its chief financial officer and a current and former member of its Board of Directors) owned approximately 7.2% of the Company’s outstanding common stock and 2,218,670 Operating Partnership units. The following is a summary of the transactions between the Company and MHI Hotels Services:

Accounts Receivable – At March 31, 2011, the Company owed $3,546 to MHI Hotels Services while at December 31, 2010, the Company was due $17,375 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. Leasehold revenue for each of the three months ended March 31, 2011 and 2010 was $160,000.

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 hotels that the Company owned at March 31, 2011, except for the Crowne Plaza Tampa Westshore, are operated by MHI Hotels Services under a master management agreement that expires between December 2014 and April 2018. The Company entered into a separate management agreement with MHI Hotels Services for the management of the Crowne Plaza Tampa Westshore that expires in March 2019. Under both management agreements, 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 any hotel is 2.0% of gross revenues for the first full fiscal year and partial fiscal year from the commencement date through December 31 of that year, 2.5% of gross revenues the second full fiscal year, and 3.0% of gross revenues for every year thereafter. Pursuant to the sale of the Holiday Inn Downtown in Williamsburg, Virginia, one of the hotels initially contributed to the Company upon its formation, MHI Hotels Services agreed that the property in Jeffersonville, Indiana shall substitute for the Williamsburg property under the master management agreement. The incentive management fee, if any, is due annually in arrears within 90 days of the end of the fiscal year and will be equal to 10.0% 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.

Management fees earned by MHI Hotels Services totaled $538,556 and $443,504 for the three months March 31, 2011 and 2010, respectively. In addition, estimated incentive management fees of $45,755 and $16,275 were accrued for the three months ended March 31, 2011 and 2010, respectively.

Employee Medical Benefits – The Company purchases employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. Premiums for employee medical benefits paid by the Company were $642,321 and $491,867 for the three months ended March 31, 2011 and 2010, respectively.

Construction Management Services – The Company has engaged MHI Hotels Services to manage certain aspects of the renovations at the Crowne Plaza Tampa Westshore and the Holiday Inn Brownstone. The Company paid construction management fees of $0 and $50,000 for the three months ended March 31, 2011 and 2010, respectively.

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9. Retirement Plan

The Company maintains a 401(k) plan for qualified employees which is subject to “safe harbor” provisions and which requires that the Company match 100% of the first 3% of employee contributions and 50% of the next 2% of employee contributions. All Company matching funds vest immediately in accordance with the “safe harbor” provision. Company contributions to the plan totaled $11,088 and $9,989 for the three months ended March 31, 2011 and 2010, respectively.

10. Unconsolidated Joint Venture

The Company owns a 25.0% indirect interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel under a management contract; (iii) the entity that entered into a lease agreement upon closing of the hotel acquisition with respect to the adjacent three-acre site on which is located a parking garage that is utilized by the hotel; and (iv) the entity that owned the junior participation in the existing mortgage. Carlyle owns a 75.0% indirect controlling interest in all these entities. The joint venture purchased the property on August 8, 2007 and began operations on September 18, 2007. Summarized financial information for this investment, which is accounted for under the equity method, is as follows:

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11. Income Taxes

The components of the income tax provision (benefit) for the three months ended March 31, 2011 and 2010 are as follows (in thousands):

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

As of March 31, 2011 and December 31, 2010, the Company had a net deferred tax asset of approximately $4.8 million and $4.7 million, respectively, of which, approximately $4.3 million and $4.2 million, respectively, are due to accumulated net operating losses.

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These loss carryforwards will begin to expire in 2024 if not utilized by then. As of March 31, 2011 and December 31, 2010, approximately $0.4 million of the net deferred tax asset is attributable to the Company’s share of start-up expenses related to the Crowne Plaza Hollywood Beach Resort, start-up expenses related to the opening of the Sheraton Louisville Riverside and the Crowne Plaza Tampa Westshore that were not deductible in the year incurred, but are being amortized over 15 years. The remainder of the net deferred tax asset is attributable to year-to-year timing differences including accrued, but not deductible, employee performance awards, vacation and sick pay, bad debt allowance and depreciation. The Company believes that it is more likely than not that the deferred tax asset will be realized and that no valuation allowance is required.

12. Earnings per Share

The limited partners’ outstanding limited partnership units in the Operating Partnership (which may be redeemed for common stock upon notice from the limited partners and following the Company’s election to redeem the units for stock rather than cash) have been excluded from the diluted earnings per share calculation as there would be no effect on the amounts since the limited partners’ share of income would also be added back to net income. The computation of basic and diluted earnings per share is presented below.

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

13. Subsequent Events

Securities Purchase Agreement – On April 18, 2011, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with Essex Illiquid, LLC and Richmond Hill Capital Partners, LP (collectively, the “Investors”), under which the Company issued and sold to the Investors in a private placement 25,000 shares of the Company’s Series A Cumulative Redeemable Preferred Stock (the “Preferred Stock”), and a warrant (the “Warrant”) to purchase 1,900,000 shares of the Company’s common stock, par value $0.01 per share, for a purchase price of $25.0 million.

Preferred Stock – The Company has designated a class of preferred stock, consisting of 27,650 shares with $0.01 par value per share, having a liquidation preference of $1,000.00 per share (the “Series A Cumulative Redeemable Preferred Stock”) pursuant to Articles Supplementary (the “Articles Supplementary”), which sets forth the preferences, rights and restrictions for the Series A Cumulative Redeemable Preferred Stock. The Series A Cumulative Redeemable Preferred Stock is non-voting and non-convertible. The Series A Cumulative Redeemable Preferred Stock has a mandatory redemption date of April 18, 2016 or upon the earlier occurrence of certain triggering events. The holders of the Series A Cumulative Redeemable Preferred Stock have a right to payment of a cumulative dividend payable (i) in cash at an annual rate of 10% and (ii) in additional shares of the Series A Cumulative Redeemable Preferred Stock at an annual rate of 2% of the liquidation preference per share. As set forth in the Articles Supplementary, the holder(s) of the Company’s Series A Cumulative Redeemable Preferred Stock will have the exclusive right, voting separately as a single class, to elect one (1) member of the Company’s board of directors. In addition, under certain circumstances as set forth in the Articles Supplementary, the holder(s) of the Company’s Series A Cumulative Redeemable Preferred Stock will be entitled to appoint a majority of the members of the board of directors. The holder(s) of the Company’s Series A Cumulative Redeemable Preferred Stock will be entitled to require that the Company redeem the Series A Cumulative Redeemable Preferred Stock under certain circumstances on such terms and at such price as is set forth in the Articles Supplementary.

Warrant – The Warrant entitles the holder(s) to purchase up to 1,900,000 shares of the Company’s common stock at an exercise price of $2.25 per share. The Warrant expires on October 18, 2016. Warrant holders will have no voting rights. The exercise price and number of shares of common stock issuable upon exercise of the Warrants are both subject to adjustment in certain cases. The Warrant also contains a cashless exercise right. Under certain circumstances as set forth in the Warrant, the holder of the Warrant will be entitled to participate in certain future securities offerings of the Company.

The Company used the net proceeds from the sale of the Preferred Stock and the Warrant to partially prepay the amounts owed by the Company under its credit agreement.

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Note Agreement – On April 18, 2011, the Company entered into a Note Agreement (the “Note Agreement”) with Essex Equity High Income Joint Investment Vehicle, LLC, as a lender (the “Lender”), pursuant to which the Company has the right to borrow up to $10,000,000 (the “Bridge Financing”). The principal amount borrowed under the Note Agreement will bear interest at the rate of 9.25% per annum, payable quarterly in arrears. The Bridge Financing will mature on the fourth anniversary of the Note Agreement or, if earlier, upon the redemption in full of the Preferred Stock. The Bridge Financing may be prepaid at the Company’s option in whole or in part at any time without penalty. Further, the Company is obligated to make prepayments in the event, and to the extent of the proceeds from, new equity issuances, certain debt incurrences and sales of assets which do not secure the Company’s obligations under the Company’s credit agreement and to repay the Bridge Financing in full following certain trigger events which also give rise to an obligation to redeem the outstanding shares of Preferred Stock. The Note Agreement provides for certain future securities pledges and/or asset liens to be granted from time to time to the Lender to secure the Bridge Financing, under the circumstances and upon the conditions set forth in the Note Agreement. The Company intends to use the net proceeds from the Bridge Financing to (i) facilitate the refinancing of the mortgage on the Crowne Plaza Jacksonville Riverfront Property and the Crowne Plaza Hampton Marina, if necessary; (ii) pay its transaction fees and expenses in respect of the Bridge Financing, the issuance and sale of the Preferred Stock and Warrant and the sixth amendment to the Company’s credit agreement; and (iii) finance ongoing working capital and general corporate needs of the Company.

Sixth Amendment to Credit Agreement – On April 18, 2011, the Company entered into a sixth amendment to the credit agreement dated effective as of April 18, 2011. Among other things, the amendment: (i) extends the final maturity date of advances under the credit agreement to May 8, 2014; (ii) provides that no additional advances may be made and no currently outstanding advances subsequently repaid or prepaid may be reborrowed; (iii) adjusts the release amounts with respect to secured hotel properties; (iv) reduces the additional interest from 4.00% to 3.50% and removes the LIBOR floor of 0.75%; and (v) adjusts certain financial covenants including restrictions relating to payment of dividends. In connection with the amendment, the Company reduced the outstanding balance on its existing credit facility by approximately $22.7 million.

Overview

We are a self-managed and self-administered REIT incorporated in Maryland in August 2004 to pursue opportunities primarily in the full-service upper-upscale and upscale segments of the hotel industry located in primary and secondary markets in the Mid-Atlantic and Southern United States. We commenced operations in December 2004 when we completed our initial public offering (the “IPO”) and thereafter consummated the acquisition of the initial properties.

Our hotel portfolio currently consists of ten full-service, upper-upscale and upscale hotels with 2,421 rooms, which operate under well-known brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. Nine of these hotels, totaling 2,110 rooms, are 100% owned by subsidiaries of our Operating Partnership. We also own a 25.0% indirect non-controlling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with Carlyle and we have leasehold interests in a resort condominium facility in Wrightsville Beach, North Carolina. As of March 31, 2011, we owned the following hotel properties:

We conduct substantially all our business through our Operating Partnership. We are the sole general partner of our Operating Partnership, and we own an approximate 74.1% 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 wholly-owned hotel properties to MHI Hospitality TRS, LLC, our TRS Lessee, which then engages a hotel management company to operate the hotels under a management contract. Our TRS Lessee has engaged MHI Hotels Services to manage our hotels. Our TRS Lessee, and its parent, MHI

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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:

Results of Operations

The following table illustrates the actual key operating metrics for each of the three months ended March 31, 2011 and 2010 for the properties we wholly-owned during each respective reporting period.

Comparison of the Three Months Ended March 31, 2011 to the Three Months Ended March 31, 2010

Revenue. Total revenue for the three months ended March 31, 2011 increased approximately $1.0 million or 5.8% to approximately $18.5 million compared to total revenue of approximately $17.5 million for the three months ended March 31, 2010. Increases in revenue at our Tampa, Florida, Wilmington, North Carolina, Jeffersonville, Indiana and Hampton, Virginia properties offset declines in revenue at our Savannah, Georgia and Laurel, Maryland properties.

Room revenue increased approximately $0.8 million or 6.7% to approximately $12.9 million for the three months ended March 31, 2011 compared to room revenue of approximately $12.1 million for the three months ended March 31, 2010. The increase in room revenue for the three months ended March 31, 2011 resulted from a 6.0% increase in ADR and a 0.7% increase in occupancy as compared to the same period in 2010. Room revenue increased at all our properties with the exception of our property in Laurel, Maryland.

Food and beverage revenues increased approximately $0.3 million or 6.0% to approximately $4.6 million for the three months ended March 31, 2011 compared to food and beverage revenues of approximately $4.3 million for the three months ended March 31, 2010. Increases in banqueting revenue at our properties in Tampa, Florida, Jeffersonville, Indiana, Raleigh, North Carolina and Wilmington, North Carolina offset decreases in food and beverage revenue at our properties in Laurel, Maryland and Savannah, Georgia.

Revenue from other operating departments for the three months ended March 31, 2011 remained constant at approximately $1.1 million compared to revenue from other operating departments for the three months ended March 31, 2010.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses and management fees, were approximately $14.5 million, an increase of approximately $0.5 million or 3.9% for the three months ended March 31, 2011 compared to total hotel operating expenses of approximately $14.0 million for the three months ended March 31, 2010. The increase in hotel operating expense was mostly attributable to an increase in operating revenue.

Rooms expense for the three months ended March 31, 2011 increased approximately $0.1 million or 2.8% to approximately $3.7 million compared to rooms expense of approximately $3.6 million for the three months ended March 31, 2010. The increase was largely attributable to higher payroll costs related to fewer vacant positions, higher unemployment taxes and employee furloughs in the prior period.

Food and beverage expenses for the three months ended March 31, 2011 increased approximately $0.1 million to approximately $3.1 million or 3.5% compared to food and beverage expenses of approximately $3.0 million for the three months ended March 31, 2010. Most of the increase in food and beverage expense was directly related to the increase in food and beverage revenues. An improvement in food and beverage margins from 29.9% to 31.5% offset the cost of higher volume.

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Indirect expenses at our wholly-owned properties for the three months ended March 31, 2011 increased approximately $0.4 million or 5.4% to approximately $7.6 million compared to indirect expenses of approximately $7.2 million for the three months ended March 31, 2010. Management fees and franchise fees increased significantly due to the increase in revenue. Energy costs increased as well due to the increase in occupancy and higher costs due to the expiration of favorable fixed rate contracts. Sales and marketing costs, repairs and maintenance, insurance, real and personal property taxes as well as general and administrative costs at the property level are also included in indirect expenses.

Depreciation and Amortization. Depreciation and amortization expense for the three months ended March 31, 2011 remained constant at approximately $2.1 million compared to depreciation and amortization expense for the three months ended March 31, 2010.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended March 31, 2011 decreased approximately $0.1 million or 9.5% to approximately $1.0 million compared to corporate general and administrative expense of approximately $1.1 million for the three months ended March 31, 2010.

Interest Expense. Interest expense for the three months ended March 31, 2011 increased approximately $0.3 million or 11.9% to approximately $2.6 million compared to interest expense of approximately $2.3 million for the three months ended March 31, 2010. The increase was the combined result of a higher effective interest rate due mostly to the June 2010 amendment to the credit agreement offset by the lower average balance of debt outstanding.

Equity Income in Joint Venture. Equity income in joint venture for the three months ended March 31, 2011 represents our 25.0% share of the net loss of the Crowne Plaza Hollywood Beach Resort. For the three months ended March 31, 2011, our 25.0% share of the net income of the hotel remained constant at approximately $0.3 million, as compared to the same for the three months ended March 31, 2010. For the three months ended March 31, 2011, the hotel reported occupancy of 88.3%, ADR of $153.19 and RevPAR of $135.28. This compares with results reported by the hotel for the three months ended March 31, 2010 of occupancy of 89.1%, ADR of $159.49 and RevPAR of $142.14.

Income Taxes. The income tax provision or benefit is primarily derived from the operations of our TRS Lessee. The Company realized income tax expense of approximately $50,000 for the three months ended March 31, 2011 as compared to an income tax benefit of approximately $0.2 million for the three months ended March 31, 2010.

Net Loss. The net loss for the three months ended March 31, 2011 increased approximately $0.2 million or 22.2% to approximately $1.3 million as compared to a net loss of approximately $1.1 million for the three months ended March 31, 2010 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 noncontrolling 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. Management believes 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 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 loss to FFO for each of the three months ended March 31, 2011 and 2010 (unaudited):

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