##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to
.



Commission file number 001-32379



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MHI HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                             |  |                                     
|------------------------------------------------------------ |  | ------------------------------------
|MARYLAND                                                     |  | 20-1531029                          
|(State or Other Jurisdiction of corporation or Organization) |  | (I.R.S. Employer Identification No.)



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).    Yes ̈No  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 November 7, 2005, there were 6,704,000 shares of
the registrants common stock issued and outstanding.



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##### Table of Contents

MHI HOSPITALITY CORPORATION

INDEX



|        |  |                                                                                       |  |     
|------- |  | ------------------------------------------------------------------------------------- |  | ----
|        |  |                                                                                       |  | Page
|        |  | PART I                                                                                |  |     
|        |  |                                                                                      
|Item 1. |  | Financial Statements                                                                  |  | 1   
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 17  
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 28  
|Item 4. |  | Controls and Procedures                                                               |  | 29  
|        |  |                                                                                      
|        |  | PART II                                                                               |  |     
|        |  |                                                                                      
|Item 1. |  | Legal Proceedings                                                                     |  | 30  
|Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 30  
|Item 3. |  | Defaults Upon Senior Securities                                                       |  | 30  
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                   |  | 30  
|Item 5. |  | Other Information                                                                     |  | 30  
|Item 6. |  | Exhibits                                                                              |  | 31  



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##### Table of Contents

PART I



Item 1.Financial Statements



MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------- | ----------- | - | ------------------------------- | - | ---------- | -
|                                                                                                                                                                      |  | MHI HospitalitySeptember 30,2005(unaudited) |             |   | MHI HospitalityDecember 31,2004 |  
|ASSETS                                                                                                                                                                |  |                                             |             |   |                                 |   |            |  
|Investment in hotel properties, net                                                                                                                                   |  | $                                           | 104,293,198 |   |                                 | $ | 78,418,173 |  
|Cash and cash equivalents                                                                                                                                             |  |                                             | 209,532     |   |                                 |   | 8,314,353  |  
|Restricted cash                                                                                                                                                       |  |                                             | 4,644,559   |   |                                 |   | 637,627    |  
|Accounts receivable                                                                                                                                                   |  |                                             | 2,024,006   |   |                                 |   | 1,161,159  |  
|Accounts receivable-affiliate                                                                                                                                         |  |                                             | 285,185     |   |                                 |   | 400,216    |  
|Prepaid expenses, inventory and other assets                                                                                                                          |  |                                             | 2,609,213   |   |                                 |   | 1,602,633  |  
|Shell Island lease purchase, net                                                                                                                                      |  |                                             | 3,191,176   |   |                                 |   | 3,500,000  |  
|Deferred financing costs, net                                                                                                                                         |  |                                             | 194,501     |   |                                 |   | 198,083    |  
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|TOTAL ASSETS                                                                                                                                                          |  | $                                           | 117,451,370 |   |                                 | $ | 94,232,244 |  
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|LIABILITIES                                                                                                                                                           |  |                                             |             |   |                                 |   |            |  
|Line of credit                                                                                                                                                        |  | $                                           | 2,000,000   |   |                                 | $ |           |  
|Mortgage loans                                                                                                                                                        |  |                                             | 42,897,598  |   |                                 |   | 25,753,188 |  
|Note payable related party                                                                                                                                            |  |                                             |            |   |                                 |   | 2,000,000  |  
|Accounts payable and accrued expenses                                                                                                                                 |  |                                             | 4,348,454   |   |                                 |   | 5,177,184  |  
|Dividends and distributions payable                                                                                                                                   |  |                                             | 1,803,973   |   |                                 |   |           |  
|Advance deposits                                                                                                                                                      |  |                                             | 408,731     |   |                                 |   | 336,302    |  
|Due to affiliate                                                                                                                                                      |  |                                             |            |   |                                 |   | 100,000    |  
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|TOTAL LIABILITIES                                                                                                                                                     |  |                                             | 51,458,756  |   |                                 |   | 33,366,674 |  
|                                                                                                                                                                      |  |                                            
|Minority Interest in Operating Partnership                                                                                                                            |  |                                             | 22,178,238  |   |                                 |   | 21,118,257 |  
|                                                                                                                                                                      |  |                                            
|Commitments and contingencies (see Note 9)                                                                                                                            |  |                                             |             |   |                                 |   |            |  
|                                                                                                                                                                      |  |                                            
|OWNERS EQUITY                                                                                                                                                        |  |                                             |             |   |                                 |   |            |  
|Preferred stock, par value $0.01, 1,000,000 shares authorized, 0 shares issued and outstanding                                                                        |  |                                             |            |   |                                 |   |           |  
|Common stock, par value $0.01, 49,000,000 shares authorized, 6,704,000 shares and 6,004,000 shares issued and outstanding at
September 30, 2005 and December 31, 2004 |  |                                             | 67,040      |   |                                 |   | 60,040     |  
|Additional paid in capital                                                                                                                                            |  |                                             | 47,760,347  |   |                                 |   | 42,221,495 |  
|Accumulated deficit                                                                                                                                                   |  |                                             | (4,013,011  | ) |                                 |   | (2,534,222 | )
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|TOTAL OWNERS EQUITY                                                                                                                                                  |  |                                             | 43,814,376  |   |                                 |   | 39,747,313 |  
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  
|TOTAL LIABILITIES AND OWNERS EQUITY                                                                                                                                  |  | $                                           | 117,451,370 |   |                                 | $ | 94,232,244 |  
|                                                                                                                                                                      |  |                                             |             |   |                                 |   |            |  



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



1



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS

(unaudited)



|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|------------------------------------------------------------------------- |  | ------------------------------------------------- | ---------- | - | ------------------------------------------------- | - | --------- | ------------------------------------------------ |  | - | ------------------------------------------------ | - |  | - | ---------- | -
|                                                                          |  | MHI HospitalityThree monthsendedSeptember 30,2005 |            |   | The PredecessorThree monthsendedSeptember 30,2004 |   |           | MHI HospitalityNine monthsendedSeptember 30,2005 |  |   | The PredecessorNine monthsendedSeptember 30,2004 |  
|REVENUE                                                                   |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Rooms department                                                          |  | $                                                 | 9,992,439  |   |                                                   | $ | 4,633,373 |                                                  |  | $ | 27,787,533                                       |   |  | $ | 13,370,476 |  
|Food and beverage department                                              |  |                                                   | 3,854,810  |   |                                                   |   | 1,753,497 |                                                  |  |   | 11,654,497                                       |   |  |   | 5,849,616  |  
|Other operating departments                                               |  |                                                   | 710,409    |   |                                                   |   | 262,539   |                                                  |  |   | 1,841,464                                        |   |  |   | 706,085    |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Total revenue                                                             |  |                                                   | 14,557,658 |   |                                                   |   | 6,649,409 |                                                  |  |   | 41,283,494                                       |   |  |   | 19,926,177 |  
|                                                                          |  |                                                   |            |  
|EXPENSES                                                                  |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Hotel operating expenses                                                  |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Rooms department                                                          |  |                                                   | 2,867,253  |   |                                                   |   | 1,187,221 |                                                  |  |   | 7,750,127                                        |   |  |   | 3,313,711  |  
|Food and beverage department                                              |  |                                                   | 2,918,404  |   |                                                   |   | 1,357,578 |                                                  |  |   | 8,303,727                                        |   |  |   | 4,284,888  |  
|Other operating departments                                               |  |                                                   | 231,354    |   |                                                   |   | 126,745   |                                                  |  |   | 579,060                                          |   |  |   | 347,126    |  
|Indirect                                                                  |  |                                                   | 5,531,525  |   |                                                   |   | 2,585,637 |                                                  |  |   | 15,593,294                                       |   |  |   | 7,460,136  |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Total hotel operating expenses                                            |  |                                                   | 11,548,536 |   |                                                   |   | 5,257,181 |                                                  |  |   | 32,226,208                                       |   |  |   | 15,405,861 |  
|                                                                          |  |                                                   |            |  
|Depreciation and amortization                                             |  |                                                   | 1,117,226  |   |                                                   |   | 566,905   |                                                  |  |   | 3,069,133                                        |   |  |   | 1,589,531  |  
|Corporate general and administrative                                      |  |                                                   | 428,051    |   |                                                   |   |          |                                                  |  |   | 1,393,216                                        |   |  |   |           |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Total operating expenses                                                  |  |                                                   | 13,093,813 |   |                                                   |   | 5,824,086 |                                                  |  |   | 36,688,557                                       |   |  |   | 16,995,392 |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|OPERATING INCOME                                                          |  |                                                   | 1,463,845  |   |                                                   |   | 825,323   |                                                  |  |   | 4,594,937                                        |   |  |   | 2,930,785  |  
|                                                                          |  |                                                   |            |  
|Other income (expense)                                                    |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Interest expense                                                          |  |                                                   | (834,470   | ) |                                                   |   | (565,029  | )                                                |  |   | (1,870,080                                       | ) |  |   | (1,708,856 | )
|Interest income                                                           |  |                                                   | 18,837     |   |                                                   |   | 427       |                                                  |  |   | 120,493                                          |   |  |   | 857        |  
|Other income - net                                                        |  |                                                   |           |   |                                                   |   | 4,496     |                                                  |  |   |                                                 |   |  |   | (3,501     | )
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Income before minority interest in operating partnership and income taxes |  |                                                   | 648,212    |   |                                                   |   | 265,217   |                                                  |  |   | 2,845,350                                        |   |  |   | 1,219,285  |  
|                                                                          |  |                                                   |            |  
|Minority Interest in predecessor company                                  |  |                                                   |           |   |                                                   |   | (18,674   | )                                                |  |   |                                                 |   |  |   | (357,632   | )
|Minority interest in operating partnership                                |  |                                                   | (345,222   | ) |                                                   |   |          |                                                  |  |   | (1,129,040                                       | ) |  |   |           |  
|Benefit from income tax                                                   |  |                                                   | 292,052    |   |                                                   |   |          |                                                  |  |   | 239,337                                          |   |  |   |           |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|NET INCOME                                                                |  | $                                                 | 595,042    |   |                                                   | $ | 246,543   |                                                  |  | $ | 1,955,647                                        |   |  | $ | 861,653    |  
|                                                                          |  |                                                   |            |   |                                                   |   |           |                                                  |  |   |                                                  |   |  |   |            |  
|Income per share                                                          |  | $                                                 | 0.09       |   |                                                   | $ |          |                                                  |  | $ | 0.29                                             |   |  | $ |           |  
|                                                                          |  |                                                   |            |  
|Weighted average number of shares outstanding                             |  |                                                   | 6,704,000  |   |                                                   |   |          |                                                  |  |   | 6,655,282                                        |   |  |   |           |  



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



2



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS

(unaudited)



|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|------------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ---------- | - | ------------------------------------------------ | - | ---------- | -
|                                                                                            |  | MHI HospitalityNine monthsendedSeptember 30,2005 |            |   | The PredecessorNine monthsendedSeptember 30,2004 |  
|Cash Flows from Operating Activities:                                                       |  |                                                  |            |   |                                                  |   |            |  
|Net Income                                                                                  |  | $                                                | 1,955,647  |   |                                                  | $ | 861,653    |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |                                                  |            |   |                                                  |   |            |  
|Depreciation and amortization                                                               |  |                                                  | 3,069,133  |   |                                                  |   | 1,589,531  |  
|Amortization of deferred financing costs                                                    |  |                                                  | 58,077     |   |                                                  |   | 58,077     |  
|Equity in net (income) loss of partnership investments                                      |  |                                                  |           |   |                                                  |   | 3,501      |  
|Minority interest in operating partnership/predecessor                                      |  |                                                  | 1,129,040  |   |                                                  |   | 357,632    |  
|Changes in assets and liabilities:                                                          |  |                                                  |            |   |                                                  |   |            |  
|Restricted cash                                                                             |  |                                                  | (4.006,932 | ) |                                                  |   | (730,684   | )
|Accounts receivable                                                                         |  |                                                  | (862,847   | ) |                                                  |   | (253,351   | )
|Inventory, prepaid expenses and other assets                                                |  |                                                  | (1,024,454 | ) |                                                  |   | (144,528   | )
|Accounts payable and accrued expenses                                                       |  |                                                  | (828,730   | ) |                                                  |   | 1,059,465  |  
|Advance deposits                                                                            |  |                                                  | 72,429     |   |                                                  |   | 67,878     |  
|Due from affiliates                                                                         |  |                                                  | 15,031     |   |                                                  |   |           |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Net cash provided by (used in) operating activities                                         |  |                                                  | (426,606   | ) |                                                  |   | 2,869,174  |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Cash flows from investing activities:                                                       |  |                                                  |            |   |                                                  |   |            |  
|Acquisition of hotel properties                                                             |  |                                                  | (3,559,324 | ) |                                                  |   |           |  
|Improvements and additions to hotel properties                                              |  |                                                  | (6,144,653 | ) |                                                  |   | (870,059   | )
|Capital contributions to unconsolidated investments                                         |  |                                                  |           |   |                                                  |   | (23,700    | )
|Distributions from unconsolidated investments                                               |  |                                                  |           |   |                                                  |   | 27,465     |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Net cash used in investing activities                                                       |  |                                                  | (9,703,977 | ) |                                                  |   | (866,294   | )
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Cash flows from financing activities:                                                       |  |                                                  |            |   |                                                  |   |            |  
|Proceeds from sale of common stock                                                          |  |                                                  | 7,000,000  |   |                                                  |   |           |  
|Members capital contributed                                                                |  |                                                  |            |   |                                                  |   | 23,700     |  
|Payment of issuance costs related to sale of common stock                                   |  |                                                  | (490,000   | ) |                                                  |   |           |  
|Members capital distributed                                                                |  |                                                  |           |   |                                                  |   | (1,301,245 | )
|Minority partner distributions                                                              |  |                                                  |           |   |                                                  |   | (368,000   | )
|Dividends and distributions paid                                                            |  |                                                  | (3,561,753 | ) |                                                  |   |           |  
|Payments on related party note                                                              |  |                                                  | (2,000,000 | ) |                                                  |   | (979,849   | )
|Proceeds from line of credit                                                                |  |                                                  | 2,000,000  |   |                                                  |   |           |  
|Proceeds from borrowing and capital leases                                                  |  |                                                  |           |   |                                                  |   | 650,000    |  
|Payment of deferred financing costs                                                         |  |                                                  | (54,496    | ) |                                                  |   |           |  
|                                                                                            |  |                                                 
|Payment of loans and capital lease obligations                                              |  |                                                  | (855,590   | ) |                                                  |   | (1,893,515 | )
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Net cash provided by (used in) financing activities                                         |  |                                                  | 2,038,161  |   |                                                  |   | (1,909,211 | )
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Net increase (decrease) in cash and cash equivalents                                        |  |                                                  | (8,089,422 | ) |                                                  |   | 93,669     |  
|Cash and cash equivalents at the beginning of the period                                    |  |                                                  | 8,314,353  |   |                                                  |   | 67,365     |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Cash and cash equivalents at the end of the period                                          |  | $                                                | 209,532    |   |                                                  | $ | 161,034    |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Supplemental disclosures:                                                                   |  |                                                  |            |   |                                                  |   |            |  
|Cash paid during the period for interest                                                    |  | $                                                | 1,808,653  |   |                                                  | $ | 1,708,856  |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Supplemental disclosures on non-cash activities:                                            |  |                                                  |            |   |                                                  |   |            |  
|Purchase of property with debt                                                              |  | $                                                | 18,000,000 |   |                                                  | $ |           |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  
|Purchase of property for units in operating partnership                                     |  | $                                                | 913,482    |   |                                                  | $ |           |  
|                                                                                            |  |                                                  |            |   |                                                  |   |            |  



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



3



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##### Table of Contents

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF OWNERS EQUITY

(unaudited)



|                                                                                   |  |              |  |                            |        |  |                     |            |   |       |   |            |   |  |   |            |  
|---------------------------------------------------------------------------------- |  | ------------ |  | -------------------------- | ------ |  | ------------------- | ---------- | - | ----- | - | ---------- | - |  | - | ---------- | -
|                                                                                   |  | Common Stock |  | Additional Paid-In Capital |        |  | Accumulated Deficit |            |   | Total |  
|                                                                                   |  | Shares       |  | ParValue                   |        |  |                    
|Balances at December 31, 2004                                                      |  | 6,004,000    |  | $                          | 60,040 |  | $                   | 42,221,495 |   |       | $ | (2,534,222 | ) |  | $ | 39,747,313 |  
|                                                                                   |  |              |  |                            |       
|Sale of common shares in connection with over-allotment of initial public offering |  | 700,000      |  |                            | 7,000  |  |                     | 6,993,000  |   |       |   |           |   |  |   | 7,000,000  |  
|Underwriters fees, offering expenses and issuance costs related to over-allotment  |  |              |  |                            |        |  |                     | (490,000   | ) |       |   |           |   |  |   | (490,000   | )
|Adjustment to Minority Interest in operating partnership                           |  |              |  |                            |        |  |                     | (964,148   | ) |       |   |            |   |  |   | (964,148   | )
|Net Income                                                                         |  |              |  |                            |        |  |                     |            |   |       |   | 1,955,647  |   |  |   | 1,955,647  |  
|Dividends declared                                                                 |  |              |  |                            |        |  |                     |            |   |       |   | (3,434,436 | ) |  |   | (3,434,436 | )
|                                                                                   |  |              |  |                            |        |  |                     |            |   |       |   |            |   |  |   |            |  
|Balances at September 30, 2005                                                     |  | 6,704,000    |  | $                          | 67,040 |  | $                   | 47,760,347 |   |       | $ | (4,013,011 | ) |  | $ | 43,814,376 |  
|                                                                                   |  |              |  |                            |        |  |                     |            |   |       |   |            |   |  |   |            |  



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



4



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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. Our hotels operate under well-known
national hotel brands such as Hilton 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
(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.



The IPO consisted of the sale of 6,000,000 shares of common stock at a price of $10 per share, resulting in gross proceeds of $60 million and net proceeds
(after deducting underwriting discounts and offering expenses) of approximately $54.8 million. On December 21, 2004 the Company issued 4,000 shares of restricted 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 from the IPO and the exercise of the underwriters over-allotment option was approximately $61.3 million.



The Company contributed all of the net proceeds from the IPO and the exercise of the underwriters over-allotment option to MHI Hospitality, L.P., a
Delaware limited partnership (the Operating Partnership), in exchange for an approximate 63.7% general and limited partnership interest in the Operating Partnership as of January 19, 2005. The Operating Partnership used
approximately $42.1 million of the net proceeds from the Company, along with 3,817,036 units of limited partner interest, to acquire all of the equity interests in the entities that own or lease the initial properties.



On July 22, 2005, the Company acquired 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, 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 our operating partnership, MHI Hospitality L.P. (the Operating Partnership), valued at approximately $913,000.



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NOTES TO FINANCIAL STATEMENTS  (Continued)



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 owned 63.2% by the Company as of July 22, 2005, 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 nine months ended September 30,
2005. For the three months and nine months ended September 30, 2004, this report includes the financial statements of MHI Hotels Services Group (MHI HSG), which is not a legal entity, but rather a combination of three hotels that
were owned by various limited liability companies and a limited liability partnership that were controlled by affiliates of MHI Hotels Services, LLC (MHI Hotels Services) all of which were acquired by the Company concurrent with the
completion of the IPO on December 21, 2004. MHI HSG is considered the predecessor to the Company for accounting purposes. Securities and Exchange Commission regulations require the inclusion of the predecessor for the periods prior to the
Companys commencement of operations. The predecessor statements of operations and cash flows for the nine months ended September 30, 2004 include the operations of MHI HSG on a historical cost basis.



Principles of Consolidation The consolidated financial
statements of the Company include the accounts of the Company and its wholly owned subsidiaries. All intercompany 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.



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 $3.0 million capital
improvement reserve account for the Hilton Jacksonville Riverfront Hotel administered by Mercantile.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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 which 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 40 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.



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 September 30, 2005 were $266,521. Amortization expense for the three months and nine months ended September 30, 2005 was $5,625
and $16,874, respectively.For the three months and nine months ended September 30, 2004, amortization expense was $2,175, and $8,174, 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



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NOTES TO FINANCIAL STATEMENTS  (Continued)



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.



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.



Earnings Per Share  Basic earnings per share is calculated by dividing net income available to common stockholders by the weighted average
common shares outstanding during the period. Diluted earnings per share are calculated by dividing net income available to common stockholders by the weighted average common shares outstanding during the period plus other potentially dilutive
securities. The outstanding Operating Partnership units (which may be converted to common shares) have been excluded from the diluted earnings per share calculation, as there would be no effect on reported diluted earnings per share. For the nine
months ended September 30, 2005, basic and diluted earnings per share were $0.29. The weighted average number of common shares outstanding used in the calculations was 6,655,282.



Stock-based Compensation The Company does not provide stock-based employee compensation.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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 predecessor financial statements to conform to the Companys presentation.



3. Acquisition of Hotel Properties



On
July 22, 2005, the Company acquired 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.



The allocation of the purchase price to the acquired assets
based on their fair values was as follows (in thousands):



|                                  |  |                                     |       
|--------------------------------- |  | ----------------------------------- | ------
|                                  |  | Hilton JacksonvilleRiverfront Hotel
|Land and land improvements        |  | $                                   | 6,892 
|Buildings and improvements        |  |                                     | 14,195
|Furniture, fixtures and equipment |  |                                     | 913   
|                                  |  |                                     |       
|                                  |  | $                                   | 22,000
|                                  |  |                                     |       



The results of
operations are included in the Companys consolidated statements of operations from the date of acquisition of this hotel. The following pro forma financial information presents the results of operations of the Company for the nine months ended
September 30, 2005 and 2004 as if the Hilton Jacksonville Hotel Riverfront acquisition, as well as the hotels acquired in 2004, had taken place on January 1, 2004. The pro forma results have



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NOTES TO FINANCIAL STATEMENTS  (Continued)



been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually occurred had the
transactions taken place on January 1, 2004, or of future results of operations (in thousands, except per share data).



|                             |  |                                                           |        |                                                           |   |       
|---------------------------- |  | --------------------------------------------------------- | ------ | --------------------------------------------------------- | - | ------
|                             |  | MHI HospitalityCorporation September 30, 2005 (unaudited) |        | MHI HospitalityCorporation September 30, 2004 (unaudited)
|Pro forma revenues           |  | $                                                         | 49,174 |                                                           | $ | 44,674
|Pro forma operating expenses |  |                                                           | 42,296 |                                                           |   | 38,812
|Pro forma operating income   |  |                                                           | 6,878  |                                                           |   | 5,862 
|Pro forma net income         |  |                                                           | 2,866  |                                                           |   | 2,035 
|Pro forma earnings per share |  |                                                           | 0.43   |                                                           |   | 0.30  
|Pro forma common shares      |  |                                                           | 6,704  |                                                           |   | 6,704 



4. Investment in Hotel Properties



Investment in hotel properties as of September 30,
2005 and December 31, 2004 consisted of the following (in thousands):



|                                  |  |                                                           |         |   |                                         |   |         |  
|--------------------------------- |  | --------------------------------------------------------- | ------- | - | --------------------------------------- | - | ------- | -
|                                  |  | MHI HospitalityCorporation September 30, 2005 (unaudited) |         |   | MHI HospitalityCorporation Dec 31, 2004 |  
|Land and land improvements        |  | $                                                         | 12,792  |   |                                         | $ | 5,689   |  
|Buildings and improvements        |  |                                                           | 89,490  |   |                                         |   | 73,641  |  
|Furniture, fixtures and equipment |  |                                                           | 20,186  |   |                                         |   | 14,485  |  
|                                  |  |                                                           |         |   |                                         |   |         |  
|                                  |  |                                                           | 122,468 |   |                                         |   | 93,815  |  
|Less: accumulated depreciation    |  |                                                           | (18,175 | ) |                                         |   | (15,397 | )
|                                  |  |                                                           |         |   |                                         |   |         |  
|                                  |  | $                                                         | 104,293 |   |                                         | $ | 78,418  |  
|                                  |  |                                                           |         |   |                                         |   |         |  



5. Debt



Line of Credit  On December 31, 2004 the Company
established a Line of Credit with Branch Banking & Trust Company (BB&T) in the amount of $23,000,000. It bears a variable rate of LIBOR plus two and one half percent (2.50%). On September 30, 2005, LIBOR was 3.864%. The primary
collateral for the credit facility is a first mortgage on the Holiday Inn Brownstone and the Hilton Philadelphia Airport, and a lien on all business assets of those properties including, but not limited to, equipment, accounts receivable, inventory,
furniture, fixtures and proceeds thereof. Under the terms of the BB&T line of credit, the Company must satisfy certain financial and non-financial covenants. As of September 30, 2005 the Company was in compliance with all of the required
covenants. Failure to satisfy these conditions and covenants would create a default under this credit facility, and the lender could require the Company to repay all outstanding indebtedness under the facility. The line had a balance of $2.0 million
as of September 30, 2005. The Company intends to use the Line of Credit for working capital and capital acquisitions as deemed appropriate by the Directors of the Company.



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NOTES TO FINANCIAL STATEMENTS  (Continued)



Mortgage Loans  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 September 30, 2005 and December 31, 2004 was $10,293,093 and $10,631,774,
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 September 30, 2005 and December 31, 2004 was $14,604,505 and $15,053,575, respectively.



On July 22, 2005 the Company purchased 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. 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 September 30, 2005 were as follows ($000s):



|      |  |   |       
|----- |  | - | ------
|2005  |  | $ | 211   
|2006  |  |   | 1,080 
|2007  |  |   | 1,168 
|2008  |  |   | 22,439
|2009  |  |   |      
|2010  |  |   | 18,000
|      |  |   |       
|Total |  | $ | 42,898
|      |  |   |       



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NOTES TO FINANCIAL STATEMENTS  (Continued)



6. 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 31, 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. As of September 30, 2005, the Company had 6,704,000 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 September 30, 2005, 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 September 30, 2005, the total number of Operating Partnership units outstanding was 3,907,605.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS - (Continued)



7. Related Party Transactions



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



Accounts Receivable At September 30, 2005 and
December 31, 2004, the Company was due $285,185 and $300,217, respectively, from MHI Hotels Services.



Note Payable Related Party  On May 11, 2005, the Company repaid its indebtedness of $2,000,000 to 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 nine months ended September 30, 2005, the Company earned $480,000 in leasehold revenue.



Sublease of Office Space  The Company subleases office space in Greenbelt, MD from MHI Hotels Services. For the nine
months ended September 30, 2005, rent expense related to the sublease totalled $22,250.



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 All of the seven hotels that the Company owned at September 30, 2005 operate under a master management agreement with MHI Hotels Services. 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 is 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 Hilton Jacksonville Riverfront 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 September 30, 2005.



For the three and nine months ended September 30, 2005, the Company paid MHI Hotels Services approximately $0.289 million and $0.816 million, respectively, in management fees.



Acquisition of Hotel Furniture and Equipment Upon acquisition of the Hilton
Jacksonville Riverfront Hotel on July 22, 2005, an affiliate of MHI Hotels Services contributed furniture, fixtures and equipment used in the operation of the Hotel and assigned its leasehold interest and



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NOTES TO FINANCIAL STATEMENTS  (Continued)



other rights relating to the property to the purchase in exchange for 90,569 units in the operating partnership, MHI Hospitality L.P. (the Operating
Partnership), valued at approximately $913,482.



Employee Medical Benefits The Company purchases employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. For the three and nine months ended September 30, 2005,
the Company paid $10,115 and $26,750, respectively for benefits.



8. Income
Taxes



The components of the benefit from income tax for
the nine months ended September 30, 2005 are as follows (in thousands):



|          |  |                                                |       |  
|--------- |  | ---------------------------------------------- | ----- | -
|          |  | Nine Months EndedSeptember 30, 2005(unaudited) |      
|Current:  |  |                                                |       |  
|Federal   |  | $                                              |      |  
|State     |  |                                                | 25    |  
|          |  |                                                |       |  
|          |  |                                                | 25    |  
|          |  |                                                |       |  
|Deferred: |  |                                                |       |  
|Federal   |  |                                                | (190) |  
|State     |  |                                                | (74)  |  
|          |  |                                                |       |  
|          |  |                                                | (264) |  
|          |  |                                                |       |  
|          |  | $                                              | (239  | )
|          |  |                                                |       |  



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



|                                     |  |                                                |        |  
|------------------------------------ |  | ---------------------------------------------- | ------ | -
|                                     |  | Nine Months EndedSeptember 30, 2005(unaudited) |       
|Statutory federal income tax expense |  | $                                              | 967    |  
|Effect of non-taxable REIT income    |  |                                                | (1,156 | )
|State income tax benefit             |  |                                                | (50    | )
|                                     |  |                                                |        |  
|                                     |  | $                                              | (239   | )
|                                     |  |                                                |        |  



As of
September 30, 2005, the Company had a net deferred tax asset of $0.44 million, primarily due to past years 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.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



The entities comprising MHI Hotels Services Group operated as limited liability companies or limited
liability partnerships and, as a result, were not subject to federal or state income taxation. Accordingly, no provision was made for federal or state income taxes in the predecessor financial statements.



9. 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 for the
three months and nine months ended September 30, 2005 was $9,387 and $28,161, 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 2005. For the three months and nine months ended September 30, 2005, rent expense was
$19,026 and $57,078, respectively.



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 for the three months and nine months ended September 30, 2005
is $33,319 and $117,847, respectively.



The Company leases
certain submerged land in the Saint Johns River in front of the Hilton Jacksonville Riverfront Hotel from the Board of Trustees of the Internal Improvement Trust Fund



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NOTES TO FINANCIAL STATEMENTS  (Continued)



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 ended September 30, 2005 was $940.



Purchase
Agreement  On September 13, 2005, the Company entered into an agreement to purchase the commercial space of the 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  All of the seven hotels
that the Company owned at September 30, 2005 operate under a ten-year master management agreement with MHI Hotels Services which expire ten years from the date management services commence (see Note 7).



Franchise Agreements  As of September 30, 2005, all of the
Companys six 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.



10. Subsequent Events



On October 11, 2005, the Company paid the dividend for the third quarter of 2005 to those stockholders and unit holders of MHI Hospitality, L.P. of
record on September 15, 2005. The dividend was $0.17 per share (unit).



On October 10, 2005, 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 December 15, 2005. The dividend is to be paid
January 11, 2006.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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 midscale segments of the hotel industry. We commenced operations in December 2004 when we completed our initial public offering and sold 6,000,000 shares of common stock, resulting in net proceeds (after deducting underwriting discounts and
offering expenses) of approximately $54.8 million. In conjunction with the initial public offering, we sold an additional 700,000 shares of common stock as a result of the exercise of the underwriters over-allotment option in January 2005,
resulting in additional proceeds of approximately $6.5 million.



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 Hilton Jacksonville Riverfront, 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 September 30, 2005, we owned the following hotel properties:



|                                  |  |                |  |                  |  |                    
|--------------------------------- |  | -------------- |  | ---------------- |  | -------------------
|Property                          |  | Numberof Rooms |  | Location         |  | Date of Acquisition
|Hilton Philadelphia Airport       |  | 331            |  | Philadelphia, PA |  | December 21, 2004  
|Holiday Inn Laurel West           |  | 207            |  | Laurel, MD       |  | December 21, 2004  
|Holiday Inn Downtown Williamsburg |  | 137            |  | Williamsburg, VA |  | December 21, 2004  
|Holiday Inn Brownstone            |  | 188            |  | Raleigh, NC      |  | December 21, 2004  
|Hilton Wilmington Riverside       |  | 274            |  | Wilmington, NC   |  | December 21, 2004  
|Hilton Savannah DeSoto            |  | 246            |  | Savannah, GA     |  | December 21, 2004  
|Hilton Jacksonville Riverfront    |  | 292            |  | Jacksonville, FL |  | July 22, 2005      
|                                  |  |                |  |                  |  |                    
|Total                             |  | 1,675          |  |                  |  |                    
|                                  |  |                |  |                  |  |                    



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 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.



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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:



| |  |  | Occupancy, or the number of rooms sold, usually expressed as a percentage of total rooms available;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | Average daily rate or ADR, which is total room revenue divided by the number of rooms sold; and
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | Revenue per available room or RevPAR, which is the room revenue divided by the total number of available rooms.
| | - |  | ---------------------------------------------------------------------------------------------------------------



Results of Operations



MHI Hospitality Corporation  Three months ended September 30, 2005



Revenue  Total revenue for the three months ended September 30, 2005 was
$14.6 million, which includes room revenue of $10.0 million, food and beverage revenue of $3.9 million and other revenue of $0.7 million. ADR, RevPAR and average Occupancy for the three months ended September 30, 2005 were $101.25, $67.62, and
66.8%, respectively.



Included in the following table are the
key hotel operating statistics for our seven hotel properties for the three months ended September 30, 2005 and for the comparable period in 2004. The statistics for the three months ended September 30, 2005 reflect the results for six
hotels for a full quarter and the Hilton Jacksonville Riverfront Hotel since the date of acquisition. The statistics for the three months ended September 30, 2004, reflect the results for the comparable period for the respective hotels. All but
one of the hotel properties, the Holiday Inn Laurel West (formerly, the Best Western Maryland Inn), Laurel, MD, was under the management of MHI Hotels Services, our current management company during the three month period ended September 30,
2004.



|          |  |                             |        |   |                   |   |       |          |  |   |          |    |  |      |   
|--------- |  | --------------------------- | ------ | - | ----------------- | - | ----- | -------- |  | - | -------- | -- |  | ---- | --
|          |  | MHI Hospitality Corporation |        |   | Current Portfolio |   |       |          |  |   |          |   
|          |  |                             |        |   |                   |   |       |         
|          |  |                             |        |   |                   |   |       |         
|          |  | For the Three Months Ended  |        |   |                   |   |       |          | 
|          |  | September 30,               |        |   | September 30,     |   |       |          |  |   |          |   
|          |  | 2005                        |        |   | 2004              |   |       | Variance |  |   | % Change |   
|ADR       |  | $                           | 101.25 |   |                   | $ | 91.41 |          |  | $ | 9.84     |    |  | 10.8 | % 
|Occupancy |  |                             | 66.8   | % |                   |   | 73.9  | %        |  |   | (7.2     | )% |  | (9.7 | )%
|RevPAR    |  | $                           | 67.62  |   |                   | $ | 67.59 |          |  | $ | 0.03     |    |  | 0.0  | % 



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During the three months ended September 30, 2005, we experienced a significant decline in occupancy
and RevPAR at the Holiday Inn Laurel West in Laurel, MD due to renovation activity. On October 7, 2005, the property was re-branded as a Holiday Inn after substantial completion of the renovation activities. As a result of the re-branding and
completion of renovations, the Company expects occupancy rates to improve for the Laurel property in future periods. The remainder of the portfolio continues to benefit from an industry rebound as well as limited growth in supply of new hotels.
This, combined with an improved mix of customers, has allowed us to increase our average daily rate.



The following table relates to the key hotel operating statistics and results of operations for MHI Hospitality Corporations hotel properties for
the three months ended September 30, 2005 and for the three months ended September 30, 2004, for our accounting predecessor, MHI Hotel Services Group. The results for the three months ended September 30, 2005 reflect the results for
six hotels for a full quarter and the Hilton Jacksonville Riverfront Hotel since the date of acquisition. The accounting predecessor consisted of three of our initial hotels.



|                               |  |                            |            |   |                         |   |           |          |  |   |           |    |  |       |   
|------------------------------ |  | -------------------------- | ---------- | - | ----------------------- | - | --------- | -------- |  | - | --------- | -- |  | ----- | --
|                               |  | MHIHospitalityCorporation  |            |   | MHI HotelsServicesGroup |   |           |          |  |   |           |   
|                               |  | For the Three Months Ended |            |   |                         |   |           |          | 
|                               |  | September 30,2005          |            |   | September 30,2004       |   |           | Variance |  |   | % Change  |   
|Key Hotel Operating Statistics |  |                            |            |   |                         |   |           |          |  |   |           |    |  |       |   
|ADR                            |  | $                          | 101.25     |   |                         | $ | 105.88    |          |  | $ | (4.62     | )  |  | (4.4  | )%
|Occupancy                      |  |                            | 66.8       | % |                         |   | 72.5      | %        |  |   | (5.7      | )% |  | (7.9  | )%
|RevPAR                         |  | $                          | 67.62      |   |                         | $ | 76.77     |          |  | $ | (9.16     | )  |  | (11.9 | )%
|Results of Operations          |  |                            |            |   |                         |   |           |          |  |   |           |    |  |       |   
|Room Revenue                   |  | $                          | 9,992,438  |   |                         | $ | 4,633,373 |          |  | $ | 5,359,065 |    |  | 115.7 | % 
|Food and Beverage Revenue      |  | $                          | 3,854,810  |   |                         | $ | 1,753,497 |          |  | $ | 2,098,313 |    |  | 119.5 | % 
|Total Operating Revenue        |  | $                          | 14,557,659 |   |                         | $ | 6,649,409 |          |  | $ | 7,908,250 |    |  | 118.9 | % 
|Total Operating Expenses       |  | $                          | 13,093,813 |   |                         | $ | 5,824,086 |          |  | $ | 7,269,727 |    |  | 124.8 | % 
|Depreciation and Amortization  |  | $                          | 1,117,226  |   |                         | $ | 566,905   |          |  | $ | 550,321   |    |  | 97.1  | % 
|Net Operating Income           |  | $                          | 1,463,846  |   |                         | $ | 825,323   |          |  | $ | 638,523   |    |  | 77.4  | % 
|Interest Expense               |  | $                          | 834,470    |   |                         | $ | 565,029   |          |  | $ | 269,441   |    |  | 47.7  | % 
|Net Income                     |  | $                          | 595,043    |   |                         | $ | 246,543   |          |  | $ | 348,500   |    |  | 141.4 | % 



Our results of
operations for the third quarter of 2005 exceeded the performance of our accounting predecessor for the comparable period of 2004. ADR decreased approximately 4.4% due to the inclusion of four additional hotels to our predecessor group. The four
additional hotels had lower ADRs than that achieved by the predecessor group in 2004. Additionally, the removal of rooms at both our Laurel and Philadelphia properties during renovation contributed to the lower occupancy levels.



Hotel Operating Expenses: Hotel operating expenses for the third quarter of 2005 were
$11.5 million. Direct hotel expenses included room expense of $2.9 million, food and beverage expense of $2.9 million, and other departmental and indirect expenses of $5.7 million. Indirect expenses include real and personal property taxes as well
as administrative and general expenses, sales and marketing, repairs and maintenance, and energy expenses. We experienced a



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significant increase in energy costs during the third quarter and anticipate this increase will continue for the foreseeable future. Historically, energy
costs have represented approximately 5% of our hotel operating expenses. A 20% increase in energy costs would represent a 1% increase in operating expenses, which would require a corresponding increase in ADR to maintain our current margins.



Depreciation and amortization: Depreciation and amortization expense
for the three months ended September 30, 2005 was $1.1 million. As most of the renovation work at Laurel, Williamsburg and Philadelphia was not completed until the end of the quarter, depreciation and amortization expense does not reflect any
additional charge related to such work.



Interest Expense: Interest
expense for the three months ending September 30, 2005 was $0.8 million. Interest expense for the this quarter was significantly higher than the previous quarters due to the new indebtedness related to the acquisition of the Hilton Jacksonville
Riverfront Hotel.



Net operating income: Net operating income for the three
months ended September 30, 2005 was $1.5 million.



MHI
Hospitality Corporation  Nine Months Ended September 30, 2005.



Revenue  Total revenue for the nine months ended September 30, 2005 was $41.3 million, which includes room revenue of $27.8 million, food and beverage revenue of $11.7 million and other revenue of $1.8 million. ADR, RevPAR
and average occupancy for the nine months ended September 30, 2005 were $100.35, $69.86, and 69.6%, respectively.



Included in the following table are the key hotel operating statistics for our seven hotel properties for the nine months ended September 30, 2005
and for the comparable period in 2004. The statistics for the nine months ended September 30, 2005 reflect the results for six hotels for a nine months and the Hilton Jacksonville Riverfront Hotel since the date of acquisition. The statistics
for the nine months ended September 30, 2004, reflect the results for nine months for seven hotels. All but one of the hotel properties, the Holiday Inn Laurel West (formerly, the Best Western Maryland Inn), Laurel, MD, was under the management
of MHI Hotels Services, our current management company during the nine month period ended September 30, 2004.



|          |  |                           |        |   |                   |   |       |          |  |   |          |    |  |      |   
|--------- |  | ------------------------- | ------ | - | ----------------- | - | ----- | -------- |  | - | -------- | -- |  | ---- | --
|          |  | MHIHospitalityCorporation |        |   | CurrentPortfolio  |   |       |          |  |   |          |   
|          |  | For the Nine Months Ended |        |   |                   |   |       |          | 
|          |  | September 30,2005         |        |   | September 30,2004 |   |       | Variance |  |   | % Change |   
|ADR       |  | $                         | 100.35 |   |                   | $ | 90.92 |          |  | $ | 9.43     |    |  | 10.4 | % 
|Occupancy |  |                           | 69.6   | % |                   |   | 72.5  | %        |  |   | (2.9     | )% |  | (4.0 | )%
|RevPAR    |  | $                         | 69.86  |   |                   | $ | 65.91 |          |  | $ | 3.95     |    |  | 6.0  | % 



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During the nine month period ended September 30, 2005, we experienced a significant decline in
occupancy and RevPAR at the Holiday Inn Laurel West in Laurel, MD due to renovation activity. In October 2005, the property was re-branded as a Holiday Inn after substantial completion of the renovation activities. The remainder of the portfolio
continues to benefit from an industry rebound as well as limited growth in supply of new hotels. This, combined with an improved mix of customers, has allowed us to increase our average daily rate significantly.



The following table relates to the key hotel operating statistics and results
of operations for MHI Hospitality Corporations hotel properties for the nine months ended September 30, 2005 and for the nine months ended September 30, 2004, for our accounting predecessor, MHI Hotel Services Group. The results for
the nine months ended September 30, 2005 reflect the results for six hotels for a full quarter and the Hilton Jacksonville Riverfront Hotel since the date of acquisition. The accounting predecessor consisted of three of our initial hotels.



|                               |  |                           |            |   |                         |   |            |          |  |   |            |    |  |       |   
|------------------------------ |  | ------------------------- | ---------- | - | ----------------------- | - | ---------- | -------- |  | - | ---------- | -- |  | ----- | --
|                               |  | MHIHospitalityCorporation |            |   | MHI HotelsServicesGroup |   |            |          |  |   |            |   
|                               |  | For the Nine Months Ended |            |   |                         |   |            |          | 
|                               |  | September 30,2005         |            |   | September 30,2004       |   |            | Variance |  |   | % Change   |   
|Key Hotel Operating Statistics |  |                           |            |   |                         |   |            |          |  |   |            |    |  |       |   
|ADR                            |  | $                         | 100.35     |   |                         | $ | 105.98     |          |  | $ | (5.63      | )  |  | (5.3  | )%
|Occupancy                      |  |                           | 69.6       | % |                         |   | 70.2       | %        |  |   | (0.6       | )% |  | (0.8  | )%
|RevPAR                         |  | $                         | 69.86      |   |                         | $ | 74.39      |          |  | $ | (4.52      | )  |  | (6.1  | )%
|Results of Operations          |  |                           |            |   |                         |   |            |          |  |   |            |    |  |       |   
|Room Revenue                   |  | $                         | 27,787,533 |   |                         | $ | 13,370,476 |          |  | $ | 14,417,057 |    |  | 107.8 | % 
|Food and Beverage Revenue      |  | $                         | 11,654,497 |   |                         | $ | 5,849,616  |          |  | $ | 5,804,881  |    |  | 99.2  | % 
|Total Operating Revenue        |  | $                         | 41,286,494 |   |                         | $ | 19,926,177 |          |  | $ | 21,357,317 |    |  | 107.2 | % 
|Total Operating Expenses       |  | $                         | 36,688,557 |   |                         | $ | 16,995,392 |          |  | $ | 19,693,165 |    |  | 115.9 | % 
|Depreciation and Amortization  |  | $                         | 3,069,133  |   |                         | $ | 1,589,531  |          |  | $ | 1,479,602  |    |  | 93.1  | % 
|Net Operating Income           |  | $                         | 4,594,937  |   |                         | $ | 2,930,785  |          |  | $ | 1,664,152  |    |  | 56.8  | % 
|Interest Expense               |  | $                         | 1,870,080  |   |                         | $ | 1,708,856  |          |  | $ | 161,224    |    |  | 9.4   | % 
|Net Income                     |  | $                         | 1,955,947  |   |                         | $ | 861,653    |          |  | $ | 1,094,294  |    |  | 127.0 | % 



Our results of
operations for the nine months ended September 30, 2005 exceeded the performance of our accounting predecessor for the comparable period of 2004. ADR decreased approximately 5.3% due to the inclusion of three additional hotels to our
predecessor group. The three additional hotels had lower ADRs than that achieved by the predecessor group in 2004. Additionally, the removal of rooms at both our Laurel and Philadelphia properties during the second and third quarters for renovation
has contributed to the lower occupancy levels.



Hotel Operating
Expenses: Hotel operating expenses were $32.2 million. Direct hotel expenses included room expense of $7.8 million, food and beverage expense of $8.3 million, other departmental and indirect expenses of $16.1 million. Indirect expenses include
real and personal property taxes as well as administrative and general expenses, sales and marketing, repairs and maintenance, and energy expenses.



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Depreciation and amortization: Depreciation and amortization expense for the nine months ended September 30,
2005 was $3.1 million. As most of the renovation work at Laurel, Williamsburg and Philadelphia was not completed until the end of the period, depreciation and amortization expense does not reflect any additional charge related to such work.



Interest Expense: Interest expense for the nine months ending
September 30, 2005 was $1.9 million.



Net operating income: Net
operating income for the nine months ended September 30 2005 was $4.6 million.



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 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.



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The following table reconciles net income to FFO for the three and nine months ended September 30, 2005 and 2004
(unaudited):



|                                    |  |                                                   |            |                                                  |   |                                                  |  |                                                 |            |  |   |          
|----------------------------------- |  | ------------------------------------------------- | ---------- | ------------------------------------------------ | - | ------------------------------------------------ |  | ----------------------------------------------- | ---------- |  | - | ---------
|                                    |  | MHI HospitalityThree monthsendedSeptember 30,2005 |            | ThePredecessorThree monthsendedSeptember 30,2004 |   | MHI HospitalityNine monthsendedSeptember 30,2005 |  | ThePredecessorNine monthsendedSeptember 30,2004
|Net income                          |  | $                                                 | 595,042    |                                                  | $ | 246,543                                          |  | $                                               | 1,955,647  |  | $ | 861,653  
|Add minority interest               |  |                                                   | 345,222    |                                                  |   | 18,674                                           |  |                                                 | 1,129,040  |  |   | 357,632  
|Add depreciation and amortization   |  |                                                   | 1,117,226  |                                                  |   | 566,905                                          |  |                                                 | 3,069,133  |  |   | 1,589,531
|                                    |  |                                                   |            |                                                  |   |                                                  |  |                                                 |            |  |   |          
|FFO                                 |  | $                                                 | 2,057,490  |                                                  | $ | 832,122                                          |  | $                                               | 6,153,820  |  | $ | 2,808,816
|                                    |  |                                                   |            |                                                  |   |                                                  |  |                                                 |            |  |   |          
|Weighted average shares outstanding |  |                                                   | 6,704,000  |                                                  |   |                                                  |  |                                                 | 6,655,282  |  |   |          
|Weighted average units outstanding  |  |                                                   | 3,886,932  |                                                  |   |                                                  |  |                                                 | 3,840,591  |  |   |          
|                                    |  |                                                   |            |                                                  |   |                                                  |  |                                                 |            |  |   |          
|Weighted average shares and units   |  |                                                   | 10,590,932 |                                                  |   |                                                  |  |                                                 | 10,495,873 |  |   |          
|                                    |  |                                                   |            |                                                 
|FFO per share and unit              |  | $                                                 | 0.19       |                                                  |   |                                                  |  | $                                               | 0.59       |  |   |          
|                                    |  |                                                   |            |                                                  |   |                                                  |  |                                                 |            |  |   |          



Liquidity and Capital Resources



As of September 30, 2005, we had cash and cash
equivalents of approximately $4.8 million, of which $4.6 million was in restricted reserve accounts and real estate tax escrows. Coincident with the purchase of the Hilton Jacksonville Riverfront Hotel, we placed $3.0 million into a capital
improvement reserve with Mercantile Safe Deposit and Trust Company, the mortgagors trustee. The Company maintains a $23.0 million line of credit with BB&T Bank, of which only $2.0 million has been drawn and remains outstanding on
September 30, 2005. The line will be used to fund future acquisitions of new hotel companies and to provide working capital as necessary. We are currently in discussions to increase the availability under the line of credit.



Operating Requirements.The Company finances its operations from
operating cash flow, which is principally derived from the operations of its hotels. Excluding the effect of the transfer to the capital improvement reserve, cash flow provided by operating activities for the nine months ended September 30,
2005 was approximately $2.6 million. We expect that the net cash provided by operations will be adequate to fund the Companys operating requirements, debt service and the payment of dividends in accordance federal income tax laws which require
us make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gain. We declared dividends of $0.17 per share (unit) paid on April 11, 2005, July 11, 2005, and October 11, 2005,
which we funded out of working capital. On October 10, 2005, we declared a dividend of $0.17 per share (unit) to be paid on January 11, 2006, which will also be paid out of working capital.



On September 13, 2005, the Company entered into an agreement to purchase
an interest in a condominium hotel property in Hollywood, Florida last operated as the Ambassador Resort. The seller will renovate the hotel and complete a condominium conversion. The Company will retain



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MHI Hotels Services to manage the hotel on its behalf. Purchase of the interest in the property and costs related to pre-opening expenses are expected to be
incurred next year and total approximately $3.0 million. Such costs will be funded out of working capital.



Capital Expenditures. We have substantially completed the renovations at three of our initial hotels and will commence renovations of the newly
acquired Jacksonville Hilton Riverfront later this year. Approximately $7.9 million of the proceeds of the initial public offering have been used during fiscal 2005 to fund renovations and capital improvements at these hotels. Cash flow used in
investing activities for the nine months ended September 30, 2005 was approximately $9.7 million. Approximately $3.6 million was used in the purchase of the Hilton Jacksonville Riverfront Hotel. Expenditures for ongoing, recurring capital
expenditures as well as renovations were $6.1 million for the nine months ended September 30, 2005.



Approximately $3.0 million has been placed into a capital improvement reserve with Mercantile Safe Deposit and Trust Company to fund renovations to the
Hilton Jacksonville Riverfront Hotel. We expect that the reserve will be sufficient to fund the planned renovations.



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



We have engaged Jones Lang LaSalle to market the Holiday Inn Downtown
Williamsburg. In the event a potential purchaser is identified, the Company intends to structure the disposition of the property as a like-kind exchange. In the event the Company is unable to reach an agreement with a potential purchaser to effect
the transaction as a like-kind exchange, the property may be sold for cash in which case there may be expense associated with the tax indemnification agreement between the Company and the contributors of the property.



Debt service requirements on our borrowings will reduce our cash flows. The
initial public offering and the related repayment of indebtedness on certain of our initial properties, the restructuring of management agreements and our execution of a new management agreement with lower management fees has reduced historical debt
service and management fee payments and, consequently, improved cash flow and liquidity.



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



| |  |  | The issuance by the operating partnership of secured and unsecured debt securities;
| | - |  | -----------------------------------------------------------------------------------



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| |  |  | The incurrence by the subsidiaries of the operating partnership of mortgage indebtedness in connection with the acquisition or refinancing of hotel properties;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The issuance of additional shares of our common stock or preferred stock;
| | - |  | -------------------------------------------------------------------------



| |  |  | The issuance of additional units;
| | - |  | ---------------------------------



| |  |  | The selective disposition of non-core assets; and
| | - |  | -------------------------------------------------



| |  |  | The sale or contribution of some of our wholly owned properties, development projects and development land to strategic joint ventures to be formed with unrelated investors, which
would have the net effect of generating additional capital through such sale or contributions.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



Capital Expenditures



We do not expect our capital expenditures to exceed our reserves for such amounts, other than costs that we expect to incur to make capital improvements
required by our franchisors including the remaining capital improvements for the Holiday Inn Laurel West (formerly, the Best Western Maryland Inn), which will be funded out of working capital. The capital improvements for the Hilton Jacksonville
Riverfront will be funded out of the capital improvement reserve maintained by Mercantile Safe and Deposit Trust Company.



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



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Inflation



We generate revenues primarily from lease payments from our TRS Lessee and net income from the operations of our TRS Lessee. Therefore, we initially will
be relying primarily on the performance of the initial properties and the ability of our hotel manager to increase revenues and to keep pace with inflation.



Operators of hotels, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures at
some or all of our hotels may limit the ability of our management company to raise room rates.



Seasonality



The
operations of the initial properties historically have been seasonal. The periods from mid-November through mid-February are traditionally slow. The months of March and April are traditionally strong, as is October. The remaining months are
generally good, but are subject to the weather and can vary significantly.



Geographic Concentration



Our hotels are
located in Florida, Georgia, North Carolina, Virginia, Maryland and Pennsylvania.



Critical Accounting Policies



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



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



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



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There were no charges for impairment recorded for the nine months ended September 30, 2005.



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



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



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



Forward Looking Statements



Information included and incorporated by reference in this Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,
and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such
forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words, such as intend, plan,
may, should, will, project, estimate, anticipate, believe, expect, continue, potential, opportunity, and similar
expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and financing plans are forward-looking statements.



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Factors, which could have a material adverse effect on our operations and future prospects, include, but are not limited
to:



| |  |  | United States economic conditions generally and the real estate market specifically;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | management and performance of our hotels;
| | - |  | -----------------------------------------



| |  |  | our plans for renovation of our hotels;
| | - |  | ---------------------------------------



| |  |  | our financing plans;
| | - |  | --------------------



| |  |  | supply and demand for hotel rooms in our current and proposed market areas;
| | - |  | ---------------------------------------------------------------------------



| |  |  | our ability to acquire additional properties and the risk that potential acquisitions may not perform in accordance with expectations;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------



| |  |  | legislative/regulatory changes, including changes to laws governing taxation of real estate investment trusts; and
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | our competition.
| | - |  | ----------------



Additional factors that could cause actual results to vary from our forward-looking statements are set forth under the Section titled Risk
Factors in our current and periodic reports filed with the SEC.



These risks and uncertainties, together with the information contained in our Form 8-K filed with the Securities and Exchange Commission on May 26, 2005 under the caption Risk Factors, should be considered in evaluating any
forward-looking statement contained in this report or incorporated by reference herein. All forward-looking statements speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All
subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section. We undertake no obligation to update or publicly release any revisions to
forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.



Item 3.Quantitative and Qualitative Disclosures About Market Risk



The effects of potential changes in interest rates prices are discussed below. Our market risk discussion includes forward-looking statements
and represents an estimate of possible changes in fair value or future earnings that would occur assuming hypothetical future movements in interest rates. These disclosures are not precise indicators of expected future losses, but only indicators of
reasonably possible losses. As a result, actual future results may differ materially from those presented. The analysis below presents the sensitivity of the market value of our financial instruments to selected changes in market interest rates.



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To meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and
variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. Although we currently do not intend to do so, from time to time we may
enter into interest rate hedge contracts such as collars, swaps, and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not hold or issue these derivative contracts for trading or
speculative purposes.



As of September 30, 2005, we have
approximately $42.9 million of fixed-rate debt and $2.0 million of variable rate debt. The weighted average interest rate on the fixed-rate debt was 7.95%. A change in market interest rates on the fixed portion of our debt would impact the fair
value of the debt, but have no impact on interest incurred or cash flows.



We currently have no interest rate hedge contracts.



Item 4.Controls and Procedures



The Chief Executive Officer and Chief Financial Officer of MHI Hospitality Corporation have evaluated the effectiveness of the disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the Exchange Act), as required by paragraph (b) of Rules 13a-15 and 15d-15 under the Exchange Act, and have concluded that as of the end of the period covered by this report, MHI
Hospitality Corporations disclosure controls and procedures were effective.



There was no change in MHI Hospitality Corporations internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the
Exchange Act during MHI Hospitality Corporations last fiscal quarter that materially affected, or is reasonably likely to materially affect, MHI Hospitality Corporations internal control over financial reporting.



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PART II



Item 1.Legal Proceedings



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



Item 2.Unregistered Sales of Equity Securities and Use of Proceeds



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



On December 16, 2004, the
Company executed an Underwriting Agreement pursuant to which the Company agreed to sell 6,000,000 shares of common stock to the underwriters named therein, with an over-allotment option to purchase up to an additional 900,000 shares. The managing
underwriters of the initial public offering were BB&T Capital Markets, Ferris Baker Watts Incorporated, J.J.B. Hilliard, W.L. Lyons, Inc. and Flagstone Securities. The offering closed on December 21, 2004. All 6,000,000 shares were sold at
a price to the public of $10 per share. On January 19, 2005, the underwriters exercised a portion of their over-allotment option in the amount of 700,000 shares. The Companys net proceeds from the offering, after deducting the
underwriting discounts and offering expenses, were approximately $61.3 million.



The remaining net proceeds of the offering were used to acquire the Hilton Jacksonville Riverfront Hotel and for general corporate purposes.



Item 3.Defaults Upon Senior Securities



Not applicable.



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



None.



Item 5.Other Information



None.



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Item 6.Exhibits



(a) Exhibits



The
following exhibits are filed as part of this Form 10-Q:



|               |  |                                                                                                                                                                                       
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description of Exhibit                                                                                                                                                                
|10.19          |  | Purchase Agreement with MCZ/Centrum Florida VI Owner, L.L.C. and MHI Hollywood LLC dated September 13, 2005                                                                           
|               | 
|31.1           |  | Certification of President and Chief Executive Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
|               | 
|31.2           |  | Certification of Chief Financial Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002              
|               | 
|32.1           |  | Certification of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                       
|               | 
|32.2           |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                     



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SIGNATURE



Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.



|                        |  |                             |  |                                                  
|----------------------- |  | --------------------------- |  | -------------------------------------------------
|                        |  | MHI HOSPITALITY CORPORATION
|                        |  |                            
|Date: November 10, 2005 |  | By:                         |  | /s/ Andrew M. Sims                               
|                        |  |                             |  | Andrew M. Sims                                   
|                        |  |                             |  | Chief Executive Officer and Chairman of the Board



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