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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 March 31, 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



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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



As of May 12, 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 |  | 15  
|        |  |                                                                                      
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 24  
|        |  |                                                                                      
|Item 4. |  | Controls and Procedures                                                               |  | 25  
|        | 
|PART II |  |                                                                                      
|        |  |                                                                                      
|Item 1. |  | Legal Proceedings                                                                     |  | 26  
|        |  |                                                                                      
|Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 26  
|        |  |                                                                                      
|Item 3. |  | Defaults Upon Senior Securities                                                       |  | 26  
|        |  |                                                                                      
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                   |  | 26  
|        |  |                                                                                      
|Item 5. |  | Other Information                                                                     |  | 26  
|        |  |                                                                                      
|Item 6. |  | Exhibits                                                                              |  | 27  



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##### Table of Contents

PART I



Item 1.Financial Statements



MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ---------- | - | ------------------------------- | - | ---------- | -
|                                                                                                                                                           |  | MHI HospitalityMarch 31, 2005(unaudited) |            |   | MHI HospitalityDecember 31,2004 |  
|ASSETS                                                                                                                                                     |  |                                          |            |   |                                 |   |            |  
|Investment in hotel properties, net                                                                                                                        |  | $                                        | 79,047,209 |   |                                 | $ | 78,418,173 |  
|Cash and cash equivalents                                                                                                                                  |  |                                          | 10,585,342 |   |                                 |   | 8,314,353  |  
|Restricted real estate tax escrows                                                                                                                         |  |                                          | 916,167    |   |                                 |   | 637,627    |  
|Accounts receivable                                                                                                                                        |  |                                          | 1,798,381  |   |                                 |   | 1,161,159  |  
|Accounts receivable-affiliate                                                                                                                              |  |                                          | 1,760,832  |   |                                 |   | 400,216    |  
|Prepaid expenses, inventory and other assets                                                                                                               |  |                                          | 2,288,648  |   |                                 |   | 1,602,633  |  
|Shell Island lease purchase, net                                                                                                                           |  |                                          | 3,397,059  |   |                                 |   | 3,500,000  |  
|Deferred financing costs, net                                                                                                                              |  |                                          | 183,265    |   |                                 |   | 198,083    |  
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|TOTAL ASSETS                                                                                                                                               |  | $                                        | 99,976,903 |   |                                 | $ | 94,232,244 |  
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|LIABILITIES & OWNERS EQUITY                                                                                                                               |  |                                          |            |   |                                 |   |            |  
|                                                                                                                                                           |  |                                         
|Mortgage loans                                                                                                                                             |  | $                                        | 25,542,994 |   |                                 | $ | 25,753,188 |  
|Note payable related party                                                                                                                                 |  |                                          | 2,000,000  |   |                                 |   | 2,000,000  |  
|Accounts payable and accrued expenses                                                                                                                      |  |                                          | 4,814,380  |   |                                 |   | 5,177,184  |  
|Dividends payable                                                                                                                                          |  |                                          | 1,139,680  |   |                                 |   |           |  
|Advance deposits                                                                                                                                           |  |                                          | 309,363    |   |                                 |   | 336,302    |  
|Due to affiliate                                                                                                                                           |  |                                          |           |   |                                 |   | 100,000    |  
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|Total liabilities                                                                                                                                          |  |                                          | 33,806,417 |   |                                 |   | 33,366,674 |  
|                                                                                                                                                           |  |                                         
|Minority Interest in Operating Partnership                                                                                                                 |  |                                          | 22,045,464 |   |                                 |   | 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 issued and outstanding at March 31, 2005 and
December 31,2004 |  |                                          | 67,040     |   |                                 |   | 60,040     |  
|Additional paid in capital                                                                                                                                 |  |                                          | 47,760,348 |   |                                 |   | 42,221,495 |  
|Accumulated deficit                                                                                                                                        |  |                                          | (3,702,365 | ) |                                 |   | (2,534,222 | )
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|TOTAL OWNERS EQUITY                                                                                                                                       |  |                                          | 44,125,023 |   |                                 |   | 39,747,313 |  
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  
|TOTAL LIABILITIES AND OWNERS EQUITY                                                                                                                       |  | $                                        | 99,976,903 |   |                                 | $ | 94,232,244 |  
|                                                                                                                                                           |  |                                          |            |   |                                 |   |            |  



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



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF OPERATIONS

(unaudited)



|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|-------------------------------------------------------------------------------- |  | ------------------------------------------------ | ---------- | - | ------------------------------------------------ | - | --------- | -
|                                                                                 |  | MHI HospitalityThree Months Ended March 31, 2005 |            |   | The PredecessorThree Months Ended March 31, 2004 |  
|Revenue                                                                          |  |                                                  |            |   |                                                  |   |           |  
|Rooms department                                                                 |  | $                                                | 7,655,583  |   |                                                  | $ | 3,503,027 |  
|Food and beverage department                                                     |  |                                                  | 3,322,736  |   |                                                  |   | 1,715,554 |  
|Other operating departments                                                      |  |                                                  | 504,528    |   |                                                  |   | 199,562   |  
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Total revenue                                                                    |  |                                                  | 11,482,847 |   |                                                  |   | 5,418,143 |  
|                                                                                 |  |                                                 
|EXPENSES                                                                         |  |                                                  |            |   |                                                  |   |           |  
|Hotel operating expenses                                                         |  |                                                  |            |   |                                                  |   |           |  
|Rooms department                                                                 |  |                                                  | 2,273,310  |   |                                                  |   | 916,458   |  
|Food and beverage department                                                     |  |                                                  | 2,472,871  |   |                                                  |   | 1,275,814 |  
|Other operating departments                                                      |  |                                                  | 156,853    |   |                                                  |   | 98,840    |  
|Indirect                                                                         |  |                                                  | 4,496,407  |   |                                                  |   | 2,229,416 |  
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Total hotel operating expenses                                                   |  |                                                  | 9,399,441  |   |                                                  |   | 4,520,528 |  
|                                                                                 |  |                                                 
|Depreciation and amortization                                                    |  |                                                  | 952,104    |   |                                                  |   | 414,053   |  
|Renovation expenses                                                              |  |                                                  | 241,503    |   |                                                  |   | 15,410    |  
|Corporate general and administrative                                             |  |                                                  | 507,875    |   |                                                  |   |          |  
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Total operating expenses                                                         |  |                                                  | 11,100,923 |   |                                                  |   | 4,949,991 |  
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|OPERATING INCOME                                                                 |  |                                                  | 381,924    |   |                                                  |   | 468,152   |  
|                                                                                 |  |                                                 
|Other income (expense)                                                           |  |                                                  |            |   |                                                  |   |           |  
|Interest expense                                                                 |  |                                                  | (495,639   | ) |                                                  |   | (570,669  | )
|Interest income                                                                  |  |                                                  | 48,311     |   |                                                  |   | 212       |  
|Other income - net                                                               |  |                                                  |           |   |                                                  |   | (7,187    | )
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Income (loss) before minority interest in operating partnership and income taxes |  |                                                  | (65,404    | ) |                                                  |   | (109,492  | )
|                                                                                 |  |                                                 
|Minority Interest in predecessor company                                         |  |                                                  |           |   |                                                  |   | (104,990  | )
|Minority interest in operating partnership                                       |  |                                                  | 36,941     |   |                                                  |   |          |  
|Income tax benefit                                                               |  |                                                  |           |   |                                                  |   |          |  
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Net income (loss)                                                                |  | $                                                | (28,463    | ) |                                                  | $ | (214,482  | )
|                                                                                 |  |                                                  |            |   |                                                  |   |           |  
|Loss per share                                                                   |  |                                                  | (0.00      | ) |                                                  |   |          |  
|                                                                                 |  |                                                 
|Weighted average number of shares outstanding                                    |  |                                                  | 6,618,444  |   |                                                  |   |          |  



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



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS

(unaudited)



|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------------------------------ | ---------- | - | ------------------------------------------------ | - | -------- | -
|                                                                                                   |  | MHI HospitalityThree Months Ended March 31, 2005 |            |   | The PredecessorThree Months Ended March 31, 2004 |  
|Cash Flows from Operating Activities:                                                              |  |                                                  |            |   |                                                  |   |          |  
|Net Income (Loss)                                                                                  |  | $                                                | (28,463    | ) |                                                  | $ | (214,482 | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                                                  |            |   |                                                  |   |          |  
|Depreciation and amortization                                                                      |  |                                                  | 952,104    |   |                                                  |   | 414,053  |  
|Equity in net (income) loss of partnership investments                                             |  |                                                  |           |   |                                                  |   | 4,814    |  
|Minority interest in operating partnership/predecessor                                             |  |                                                  | (36,941    | ) |                                                  |   | 104,990  |  
|Changes in assets and liabilities:                                                                 |  |                                                  |            |   |                                                  |   |          |  
|Restricted cash                                                                                    |  |                                                  | (278,540   | ) |                                                  |   | 448,071  |  
|Accounts receivable                                                                                |  |                                                  | (637,222   | ) |                                                  |   | (203,732 | )
|Inventory and prepaid expenses                                                                     |  |                                                  | (686,015   | ) |                                                  |   | (54,397  | )
|Other assets                                                                                       |  |                                                  | 117,759    |   |                                                  |   | 3,316    |  
|Accounts payable and accrued expenses                                                              |  |                                                  | (362,803   | ) |                                                  |   | 334,532  |  
|Advance deposits                                                                                   |  |                                                  | (26,939    | ) |                                                  |   | 145,669  |  
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Net cash provided by (used in ) operating activities                                               |  |                                                  | (987,060   | ) |                                                  |   | 982,834  |  
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Cash flows from investing activities:                                                              |  |                                                  |            |   |                                                  |   |          |  
|Improvements and additions to hotel properties                                                     |  |                                                  | (1,581,140 | ) |                                                  |   | (190,790 | )
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Net cash used in investing activities                                                              |  |                                                  | (1,581,140 | ) |                                                  |   | (190,790 | )
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Cash flows from financing activities:                                                              |  |                                                  |            |   |                                                  |   |          |  
|Proceeds from sale of common stock                                                                 |  |                                                  | 7,000,000  |   |                                                  |   |         |  
|Payment of issuance costs related to sale of common stock                                          |  |                                                  | (490,000   | ) |                                                  |   |         |  
|Payments to related party                                                                          |  |                                                  | (1,460,616 | ) |                                                  |   |         |  
|Payment of loans and capital lease obligations                                                     |  |                                                  | (210,195   | ) |                                                  |   | (91,660  | )
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Net cash provided by (used in) financing activities                                                |  |                                                  | 4,839,189  |   |                                                  |   | (91,660  | )
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Net increase in cash and cash equivalents                                                          |  |                                                  | 2,270,989  |   |                                                  |   | 700,384  |  
|                                                                                                   |  |                                                 
|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                                                 |  | $                                                | 10,585,342 |   |                                                  | $ | 767,749  |  
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  
|Supplemental disclosures:                                                                          |  |                                                  |            |   |                                                  |   |          |  
|Cash paid during the period for interest                                                           |  | $                                                | 522,698    |   |                                                  | $ | 570,669  |  
|                                                                                                   |  |                                                  |            |   |                                                  |   |          |  



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



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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF OWNERS EQUITY

(unaudited)



|                                                                                  |  |              |  |                           |        |  |                    |            |   |       |   |            |   |  |   |            |  
|--------------------------------------------------------------------------------- |  | ------------ |  | ------------------------- | ------ |  | ------------------ | ---------- | - | ----- | - | ---------- | - |  | - | ---------- | -
|                                                                                  |  | Common Stock |  | AdditionalPaid-In Capital |        |  | AccumulatedDeficit |            |   | Total |  
|                                                                                  |  | Shares       |  | Par Value                 |        |  |                   
|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 overallotment of initial public offering |  | 700,000      |  |                           | 7,000  |  |                    | 6,993,000  |   |       |   |           |   |  |   | 7,000,000  |  
|Underwriters fees related to overallotment                                        |  |              |  |                           |        |  |                    | (490,000   | ) |       |   |           |   |  |   | (490,000   | )
|Adjustment to Minority Interest in operating partnership                          |  |              |  |                           |        |  |                    | (964,147   | ) |       |   |            |   |  |   | (964,147   | )
|Net Income (Loss)                                                                 |  |              |  |                           |        |  |                    |            |   |       |   | (28,463    | ) |  |   | (28,463    | )
|Dividends declared                                                                |  |              |  |                           |        |  |                    |            |   |       |   | (1,139,680 | ) |  |   | (1,139,680 | )
|                                                                                  |  |              |  |                           |        |  |                    |            |   |       |   |            |   |  |   |            |  
|Balances at March 31, 2005                                                        |  | 6,704,000    |  | $                         | 67,040 |  | $                  | 47,760,348 |   |       | $ | (3,702,365 | ) |  | $ | 44,125,023 |  
|                                                                                  |  |              |  |                           |        |  |                    |            |   |       |   |            |   |  |   |            |  



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



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS



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 Upper Upscale and
Midscale hotels located in primary and secondary markets in the mid-Atlantic and Southeastern regions of the United States. The Company operates 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 $55.8 million. On December 21, 2004
the Company issued 4,000 shares of common stock to its independent directors. On January 19, 2005, the Company sold an additional 700,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the
exercise of the underwriters over-allotment option, resulting in additional net proceeds of approximately $6.5 million. The total net proceeds from the IPO and the exercise of the underwriters over-allotment option were approximately
$62.4 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.



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 63.7% by the Company as of January 19, 2005, leases its hotels to subsidiaries of MHI Hospitality TRS Holding Corporation, MHI Hospitality TRS, LLC, (collectively, MHI TRS), a wholly owned subsidiary of the Operating
Partnership. MHI TRS then engages hotel management companies to operate the hotels under management contracts. MHI TRS is treated as a taxable REIT subsidiary for federal income tax purposes.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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 beginning with its commencement of operations on
December 21, 2004. Prior to December 21, 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 three months ended March 31, 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 Mutual of New York (MONY). MONY holds the mortgages on the Hilton
Wilmington Riverside and the Hilton Savannah DeSoto.



Fair
Value of Financial Instruments The Companys financial instruments include cash and cash equivalents, accounts receivable, accounts payable and accrued expenses. Due to their short maturities, 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.



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.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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.



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 March 31, 2005 were $227,937. Amortization expense for the period ended March 31, 2005 was $5,458.



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



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



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



Income
Taxes The Company intends to elect 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.



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MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



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 (Loss) Per Share Basic earnings (loss) per share is calculated by dividing net income (loss) available to common stockholders by
the weighted average common shares outstanding during the period. Diluted earnings (loss) per share are calculated by dividing net income (loss) 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 (loss) per share calculation as there would be no effect on reported
diluted earnings (loss) per share. For the period ended March 31, 2005, basic and diluted earnings (loss) per share were $(.00). The weighted average number of common shares outstanding used in the calculations was 6,618,444.



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



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 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



There were no new acquisitions in the quarter ended March 31, 2005.



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



4. Investment in Hotel Properties



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



|                                     |  |                                                       |         |   |                                              |   |         |  
|------------------------------------ |  | ----------------------------------------------------- | ------- | - | -------------------------------------------- | - | ------- | -
|                                     |  | MHI HospitalityCorporation March 31, 2005 (unaudited) |         |   | MHI HospitalityCorporation December 31, 2004 |  
|Land and land improvements           |  | $                                                     | 5,689   |   |                                              | $ | 5,689   |  
|Buildings and leasehold improvements |  |                                                       | 73,983  |   |                                              |   | 73,641  |  
|Furniture, fixtures and equipment    |  |                                                       | 15,603  |   |                                              |   | 14,485  |  
|                                     |  |                                                       |         |   |                                              |   |         |  
|                                     |  |                                                       | 95,275  |   |                                              |   | 93,815  |  
|Less: accumulated depreciation       |  |                                                       | (16,228 | ) |                                              |   | (15,397 | )
|                                     |  |                                                       |         |   |                                              |   |         |  
|                                     |  | $                                                     | 79,047  |   |                                              | $ | 78,418  |  
|                                     |  |                                                       |         |   |                                              |   |         |  



5. Mortgage Loans



The Company assumed existing mortgage debt with The Mutual of New York
Life Insurance Company (MONY) 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. Interest is based on a fixed rate of 7.49%. The outstanding balance due on the loan as of
December 31, 2004 was $10,631,774. The balance as of March 31, 2005 was $10,520,843.



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 September, 19, 2019. 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%. 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 December 31, 2004 was $15,053,575. The balance as of March 31, 2005 was $14,922,058.



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 Rate plus two and one half percent (2.50%). The LIBOR Rate on March 31, 2005 was 2.89. 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 limited to equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof.



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



Under the terms of the BB&T line of credit, we must satisfy certain financial and non-financial covenants. As of March 31, 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 zero ($0.00) as of March 31, 2005. The
Company intends to use the Line of Credit for capital acquisitions as deemed appropriate by the Directors of the Company.



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 $55.8 million. On January 19, 2005, the Company sold an additional 700,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the exercise of the 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 $62.3 million. Also, on December 31, 2004 the Company issued 4,000
shares of common stock to its independent directors. As of March 31, 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 March 31, 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 March 31, 2005, the total number of Operating Partnership units outstanding was 3,817,036.



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##### Table of Contents

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 March 31, 2005 the Company was due $1,760,832 from MHI Hotels Services, LLC.



Note Payable Related Party  At March 31, 2005 the Company was
indebted on two long term notes payable in the aggregate amount of $2,000,000 to MHI Hotels Services.



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



Management Agreements All of the six hotels that the Company owned at March 31, 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 hotels is 2.0% in 2005, rising to 2.5% in 2006 and
3.0% thereafter of total gross revenues from the hotels. 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.



For the period ended March
31, 2005, the Company paid MHI Hotels Services approximately $0.227 million in management fees.



8. Income Taxes



The
Company will elect to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. To qualify as a REIT, the Company must meet a number of organizational and operational requirements, including a requirement that it currently
distribute at least 90% of its taxable income (excluding net capital gains) to its stockholders. 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 Holding Inc., the Companys wholly owned taxable REIT subsidiary. MHI Hospitality TRS, which leases the Companys hotels from the Operating Partnership, is subject to federal and state income taxes. Since both the Company
and MHI Hospitality TRS sustained losses in the eleven day period of operation, no tax liability exists, unless the Company were to lose REIT status. If that occurred the Company would be subject to regular corporate income tax rates at the state
and federal level.



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



For the period ended March 31, 2005, there was no material change in our tax position. No income or income benefit was recognized in the period. The
balance sheet continues to reflect the temporary differences that were accrued as of December 31, 2004.



The tax effect of each type of temporary difference and carry forward that gives rise to the deferred tax assets and liabilities as of March 31, 2005 are
as follows (in thousands):



|                               |  |                            |      
|------------------------------ |  | -------------------------- | -----
|                               |  | March 31, 2005 (unaudited)
|Deferred tax assets:           |  |                            |      
|Start-up costs                 |  | $                          | 150  
|Net operating loss             |  |                            | 884  
|                               |  |                            |      
|                               |  | $                          | 1,034
|                               | 
|Deferred tax liability:        |  |                            |      
|Investment in hotel properties |  | $                          | 24   
|                               |  |                            |      
|Total benefit                  |  | $                          | 1,010
|                               |  |                            |      
|Valuation allowance            |  | $                          | 810  
|                               |  |                            |      
|Net deferred tax asset         |  | $                          | 200  
|                               |  |                            |      



The Company has
reserved $810,000 of its deferred tax asset due to the limited operation history of MHI Hospitality Corporation. The Company believes that MHI TRS will generate sufficient taxable income to realize in full this deferred tax asset.



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.



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



9. Commitments and Contingencies



Ground and Building 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 quarter ended March 31, 2005 was $9,387.



The Company leases, as Landlord, the premises being the entire fourteenth floor 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 period ended March 31, 2005, the rent expense was $19,026.



Management Agreement  All of the six hotels that the Company owned at March 31, 2005 operate under a master management agreement with MHI
Hotels Services (see Note 7).



Franchise Agreements
 As of March 31, 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 replacement and renewals at the properties.
Contributions to the property improvement fund are based on a percentage of gross revenues or receipts at each hotel equating to 5%.



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



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS  (Continued)



10. Subsequent Events



On April 11, 2005, the Company paid the dividend for the first quarter of 2005 to those stockholders (unit holders) of record on March 15, 2005. The dividend was $0.17 per share (unit).



On April 18, 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 June 15, 2005. The dividend is to be paid July 11, 2005.



The Company is actively pursuing additional new hotel acquisitions, which fit our business model. Although there are several potential targets, none are
under contract at this time.



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##### Table of Contents

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



For our first full fiscal quarter of operations following our December 21, 2004 public offering, the operating results for our six initial properties
exceeded results for the comparable period in 2004. Our first quarter results showed strong RevPar and ADR growth and steady occupancy. Renovation work on our Philadelphia, Laurel and Williamsburg properties continues to be on pace for completion in
the fall of 2005 and opportunities for additional acquisitions are being examined.



Overview



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



We completed our initial public offering in December 2004 and sold 6,000,000 shares of common stock, resulting in net proceeds (after deducting
underwriting discounts and offering expenses) of approximately $55.8 million. In conjunction with the initial public offering, we sold an additional 700,000 shares of common stock as a result of the exercise of the underwriters over-allotment
option in January 2005, resulting in additional proceeds of approximately $6.5 million. In addition, we entered into a $23.0 million Line of Credit with BB&T that will be used to facilitate acquisitions of new hotel properties and other cash
flow needs of the Company as deemed appropriate by the Directors of the Company. See Liquidity and Capital Resources.



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.



Our hotel portfolio consists of six full-service, upper upscale and midscale hotels. We own a 100% interest in all of our initial hotels. We also have leasehold interest in a resort condominium facility. In accordance
with generally accepted accounting principles, the majority interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and minority interests held by the controlling holders of our accounting predecessor in hotels acquired
from third parties are recorded at historical cost basis. Minority interests in those entities that comprise our accounting predecessor and the interests in hotels, other than those held by the controlling members of our accounting predecessor,
acquired from third parties are recorded at fair value.



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##### Table of Contents

Results of Operations



In the hotel industry, most categories of operating costs, with the exception of franchise, management, and credit card fees
and the costs of the food, 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.
| | - |  | ---------------------------------------------------------------------------------------------------------------



Included in the following table are the key hotel operating statistics for
our six initial hotel properties for the quarter ended March 31, 2005 and for the comparable period in 2004. For the quarter ended March 31, 2004, one of the hotel properties, the Best Western Maryland Inn, Laurel, MD, was not under the management
of MHI Hotels Services, our current management company.



|           |  |                            |       |   |                   |   |       |          |  |   |          |   |  |      |  
|---------- |  | -------------------------- | ----- | - | ----------------- | - | ----- | -------- |  | - | -------- | - |  | ---- | -
|           |  | MHI HospitalityCorporation |       |   | Initial Portfolio |   |       |          |  |   |          |  
|           |  | For the Quarter Ended      |       |   |                   |   |       |          | 
|           |  | March 31, 2005             |       |   | March 31, 2004    |   |       | Variance |  |   | % Change |  
|ADR        |  | $                          | 92.19 |   |                   | $ | 85.15 |          |  | $ | 7.04     |   |  | 8.3  | %
|RevPAR     |  | $                          | 61.59 |   |                   | $ | 55.0  |          |  | $ | 6.59     |   |  | 12.0 | %
|Occupancy% |  |                            | 66.8  | % |                   |   | 64.6  | %        |  |   | 2.2      | % |  | 3.4  | %



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##### Table of Contents

MHI Hospitality Corporation  Comparison period ended March 31, 2005 to MHI Hotels Services Group period ended
March 31,2004.



|                              |  |                            |            |   |                          |   |           |          |  |   |           |   |  |       |   
|----------------------------- |  | -------------------------- | ---------- | - | ------------------------ | - | --------- | -------- |  | - | --------- | - |  | ----- | --
|                              |  | MHI HospitalityCorporation |            |   | MHI Hotels ServicesGroup |   |           |          |  |   |           |  
|                              |  | For the Quarter Ended      |            |   |                          |   |           |          | 
|                              |  | March 31, 2005             |            |   | March 31, 2004           |   |           | Variance |  |   | % Change  |  
|ADR                           |  | $                          | 92.19      |   |                          | $ | 97.66     |          |  | $ | (5.47     | ) |  | (5.6  | )%
|RevPAR                        |  | $                          | 61.59      |   |                          | $ | 58.56     |          |  | $ | 3.03      |   |  | 5.2   | % 
|Occupancy%                    |  |                            | 66.8       | % |                          |   | 60.0      | %        |  |   | 6.9       | % |  | 11.4  | % 
|Room Revenue                  |  | $                          | 7,655,583  |   |                          | $ | 3,503,027 |          |  | $ | 4,152,556 |   |  | 118.5 | % 
|Food and Beverage Revenue     |  | $                          | 3,322,736  |   |                          | $ | 1,715,554 |          |  | $ | 1,607,182 |   |  | 93.7  | % 
|Total Operating Revenue       |  | $                          | 11,482,847 |   |                          | $ | 5,418,143 |          |  | $ | 6,064,704 |   |  | 111.9 | % 
|Total Operating Expenses      |  | $                          | 11,100,923 |   |                          | $ | 4,934,581 |          |  | $ | 6,166,342 |   |  | 125.0 | % 
|Depreciation and Amortization |  | $                          | 952,104    |   |                          | $ | 414,053   |          |  | $ | 538,051   |   |  | 130.0 | % 
|Net Operating Income          |  | $                          | 381,924    |   |                          | $ | 483,562   |          |  | $ | (101,638  | ) |  | (21.0 | )%
|Interest Expense              |  | $                          | 495,639    |   |                          | $ | 570,669   |          |  | $ | (75,030   | ) |  | (13.1 | )%
|Net Loss                      |  | $                          | (28,463    | ) |                          | $ | (214,482  | )        |  | $ | 186,019   |   |  | 86.7  | % 



The data above relates
to the results of operations for MHI Hospitality Corporations six initial hotel properties for the period ended March 31, 2005 and for the period ended March 31, 2004, for our accounting predecessor, MHI Hotel Services Group. The accounting
predecessor consisted of three of our initial hotels.



Our
results of operations for the first quarter of 2005 exceeded the performance of our accounting predecessor for the comparable period of 2004, with the exception of net operating income, which declined slightly due to depreciation and capital
expenditures, and ADR, which decreased approximately 5.6% 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.



MHI Hospitality Corporation  Three months ended March 31, 2005.



Revenue:Total revenue for the three months ended March 31, 2005
was $11.5 million, which includes room revenue of $7.7 million, food and beverage revenue of $3.3 million and other revenue of $0.5 million. ADR, RevPAR and average occupancy for the three months ended March 31, 2005 were $92.19, $61.59, and 66.8%
respectively.



Hotel Operating Expenses: Hotel operating expenses,
excluding depreciation and amortization and expensed capital items, was $9.4 million. Direct hotel expenses included room expense of $2.3 million, food and beverage expense of $2.5 million, other departmental and indirect expenses of $4.7 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.



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##### Table of Contents

Depreciation and amortization: Depreciation and amortization expense for the three months ended March 31, 2005 was
$1.0 million.



Interest Expense: Interest expense for the three months
period ending March 31, 2005 was $0.5 million.



Net operating income:
Net operating income for the three months ended March 31, 2005 was $0.4 million.



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##### Table of Contents

MHI HOSPITALITY CORPORATION AND PREDECESSOR

CONSOLIDATED AND COMBINED FFO RECONCILIATION



The following table reconciles net loss to FFO for the quarter ended March 31, 2005



|                                  |  |                                            |            |   |                                            |   |          |  
|--------------------------------- |  | ------------------------------------------ | ---------- | - | ------------------------------------------ | - | -------- | -
|                                  |  | MHI HospitalityQuarter endedMarch 31, 2005 |            |   | The PredecessorQuarter endedMarch 31, 2004 |  
|Net income (loss)                 |  | $                                          | (28,463    | ) |                                            | $ | (214,482 | )
|Add minority interest             |  |                                            | (36,941    | ) |                                            |   | 104,990  |  
|Add depreciation and amortization |  |                                            | 952,104    |   |                                            |   | 414,053  |  
|                                  |  |                                            |            |   |                                            |   |          |  
|FFO                               |  | $                                          | 886,700    |   |                                            | $ | 304,561  |  
|                                  |  |                                            |            |   |                                            |   |          |  
|Shares outstanding                |  |                                            | 6,704,000  |   |                                            |   |          |  
|Units outstanding                 |  |                                            | 3,817,036  |   |                                            |   |          |  
|                                  |  |                                           
|Total shares and units            |  |                                            | 10,521,036 |   |                                            |   |          |  
|                                  |  |                                           
|FFO per share and unit            |  | $                                          | 0.08       |   |                                            |   |          |  
|                                  |  |                                            |            |   |                                            |   |          |  



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 (loss) 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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##### Table of Contents

Liquidity and Capital Resources



As of March 31, 2005, we had cash and cash equivalents of approximately $10.6 million which amount includes proceeds from
our initial public offering and replacement reserve accounts. We intend to use the remaining proceeds from the initial public offering and the underwriters exercise of their over-allotment option to invest in additional hotel properties as
suitable opportunities arise and to renovate three of our existing hotel properties.



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



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



In addition to recurring capital
expenditures, renovations and debt service as uses of cash and requirements for short-term liquidity, we are required to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gain. We
declared a dividend of $0.17 per share paid on April 11, 2005, which we funded out of working capital. On April 18, 2005, we declared a dividend payable on July 11, 2005, which will also be paid from working capital.



We expect to fund our short-term liquidity requirements, including working
capital, through a combination of cash flows from operating activities and borrowings under a $23.0 million secured revolving line of credit that we entered into following the closing of our initial public offering.



Debt service requirements on our borrowings will reduce our cash flows. The
initial public offering and the related repayment of indebtedness on certain of our initial properties, the restructuring of management agreements and our execution of a new management agreement with lower management fees will reduce historical debt
service and management fee payments and, consequently, improve cash flow and liquidity. The new management fees positively impacted cash flow by approximately $117,000 for the first quarter of 2005.



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



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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;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | 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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We are currently engaged in negotiations for an acquisition which, if consummated, would require approximately $7.5 million in cash. The company would
finance the balance of the transaction with debt.



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 or the capital improvements anticipated for the Best Western Maryland Inn which will be funded with the proceeds from the initial public
offering.



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



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Inflation



We generate revenues primarily from lease payments from our TRS Lessee and net income due to 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 companies 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 initial hotels are located in North Carolina, Georgia, 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 arc 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 quarter ended March 31, 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. 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;
| | - |  | ------------------------------------------------------------------------------------



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| |  |  | 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 Registration Statement on Form S-11 (SEC File No. 333118873).



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



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.



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.



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As of March 31, 2005, we have approximately $27.5 million of fixed-rate debt and no variable rate debt.
The weighted average interest rate on the fixed-rate debt was 7.79%. 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.



We intend to use the remaining net proceeds to acquire additional hotel properties 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                                                                                                                                                                
|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: May 13, 2005 |  | By:                         |  | /s/ Andrew M. Sims                               
|                   |  |                             |  | Andrew M. Sims                                   
|                   |  |                             |  | Chief Executive Officer and Chairman of the Board



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