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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549





FORM 10-Q







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

For the quarterly period ended September 30, 2008

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





MHI HOSPITALITY CORPORATION

(Exact name of registrant as specified in its
charter)







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

4801 Courthouse Street, Suite 201, Williamsburg, Virginia 23188

Telephone Number (757) 229-5648





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

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



|                           |  |                             
|-------------------------- |  | ----------------------------
|Large Accelerated Filer   ̈ |  | Accelerated Filer   ̈        
|Non-accelerated Filer   ̈   |  | Smaller Reporting Company  x

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

As of November 13, 2008, there were 6,939,613 shares of the registrants common stock issued and outstanding.









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MHI HOSPITALITY CORPORATION

INDEX



|         |  |                                                                                       |  |     
|-------- |  | ------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                       |  | Page
|PART I  
|         |  |                                                                                      
|Item 1.  |  | Financial Statements                                                                  |  | 3   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 19  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 30  
|Item 4T  |  | Controls and Procedures                                                               |  | 30  
|        
|PART II 
|         |  |                                                                                      
|Item 1.  |  | Legal Proceedings                                                                     |  | 31  
|Item 1A. |  | Risk Factors                                                                          |  | 31  
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 31  
|Item 3.  |  | Defaults Upon Senior Securities                                                       |  | 31  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                   |  | 31  
|Item 5.  |  | Other Information                                                                     |  | 31  
|Item 6.  |  | Exhibits                                                                              |  | 31  



2



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##### Table of Contents

PART I



|Item 1. | Financial Statements
|------- | --------------------

MHI
HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----------- | - | ----------------- | - | ----------- | -
|                                                                                                                                                                                    |  | September 30, 2008 |             |   | December 31, 2007 |  
|                                                                                                                                                                                    |  | (unaudited)        |             |   |                   |  
|ASSETS                                                                                                                                                                              |  |                    |             |   |                   |   |             |  
|Investment in hotel properties, net                                                                                                                                                 |  | $                  | 152,329,133 |   |                   | $ | 109,430,559 |  
|Properties under development                                                                                                                                                        |  |                    | 21,836,583  |   |                   |   | 31,237,237  |  
|Investment in joint venture                                                                                                                                                         |  |                    | 10,560,538  |   |                   |   | 5,583,072   |  
|Cash and cash equivalents                                                                                                                                                           |  |                    | 6,527,170   |   |                   |   | 3,988,700   |  
|Restricted cash                                                                                                                                                                     |  |                    | 2,463,580   |   |                   |   | 1,750,029   |  
|Accounts receivable                                                                                                                                                                 |  |                    | 1,618,845   |   |                   |   | 1,666,417   |  
|Accounts receivable-affiliate                                                                                                                                                       |  |                    | 32,494      |   |                   |   | 11,814      |  
|Prepaid expenses, inventory and other assets                                                                                                                                        |  |                    | 4,475,181   |   |                   |   | 2,550,112   |  
|Notes receivable, net                                                                                                                                                               |  |                    | 100,000     |   |                   |   | 400,000     |  
|Shell Island lease purchase, net                                                                                                                                                    |  |                    | 1,955,882   |   |                   |   | 2,264,705   |  
|Deferred financing costs, net                                                                                                                                                       |  |                    | 1,328,363   |   |                   |   | 1,076,345   |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL ASSETS                                                                                                                                                                        |  | $                  | 203,227,769 |   |                   | $ | 159,958,990 |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|                                                                                                                                                                                    |  |                   
|LIABILITIES                                                                                                                                                                         |  |                    |             |   |                   |   |             |  
|Line of credit                                                                                                                                                                      |  | $                  | 67,187,858  |   |                   | $ | 34,387,858  |  
|Mortgage loans                                                                                                                                                                      |  |                    | 70,967,127  |   |                   |   | 55,000,000  |  
|Accounts payable and other accrued liabilities                                                                                                                                      |  |                    | 7,382,324   |   |                   |   | 8,478,441   |  
|Dividends and distributions payable                                                                                                                                                 |  |                    | 1,815,127   |   |                   |   | 1,807,883   |  
|Advance deposits                                                                                                                                                                    |  |                    | 688,050     |   |                   |   | 408,912     |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL LIABILITIES                                                                                                                                                                   |  |                    | 148,040,487 |   |                   |   | 100,083,094 |  
|Minority interest in operating partnership                                                                                                                                          |  |                    | 17,965,206  |   |                   |   | 19,689,453  |  
|                                                                                                                                                                                    |  |                   
|Commitments and contingencies (see Note 7)                                                                                                                                          |  |                    |             |   |                   |   |             |  
|                                                                                                                                                                                    |  |                   
|SHAREHOLDERS 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, 6,939,613 shares and 6,897,000 shares issued and outstanding at
September 30, 2008 and December 31, 2007, respectively |  |                    | 69,396      |   |                   |   | 68,970      |  
|Additional paid in capital                                                                                                                                                          |  |                    | 48,558,275  |   |                   |   | 48,321,505  |  
|Distributions in excess of retained earnings                                                                                                                                        |  |                    | (11,405,595 | ) |                   |   | (8,204,032  | )
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL SHAREHOLDERS EQUITY                                                                                                                                                          |  |                    | 37,222,076  |   |                   |   | 40,186,443  |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                          |  | $                  | 203,227,769 |   |                   | $ | 159,958,990 |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  

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



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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)



|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|-------------------------------------------------------------------------------- |  | ------------------------------------ | ---------- | - | ------------------------------------ | - | ---------- | ----------------------------------- |  | - | ----------------------------------- | - |  | - | ---------- | -
|                                                                                 |  | Three months endedSeptember 30,
2008 |            |   | Three months endedSeptember 30,
2007 |   |            | Nine months endedSeptember 30, 2008 |  |   | Nine months endedSeptember 30, 2007 |  
|REVENUE                                                                          |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Rooms department                                                                 |  | $                                    | 12,055,723 |   |                                      | $ | 11,683,189 |                                     |  | $ | 36,680,246                          |   |  | $ | 35,919,953 |  
|Food and beverage department                                                     |  |                                      | 4,040,957  |   |                                      |   | 4,115,491  |                                     |  |   | 13,319,651                          |   |  |   | 14,311,188 |  
|Other operating departments                                                      |  |                                      | 1,085,229  |   |                                      |   | 928,091    |                                     |  |   | 3,154,402                           |   |  |   | 2,788,738  |  
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Total revenue                                                                    |  |                                      | 17,181,909 |   |                                      |   | 16,726,771 |                                     |  |   | 53,154,299                          |   |  |   | 53,019,879 |  
|EXPENSES                                                                         |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Hotel operating expenses                                                         |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Rooms department                                                                 |  |                                      | 3,473,123  |   |                                      |   | 3,042,175  |                                     |  |   | 10,219,413                          |   |  |   | 9,356,688  |  
|Food and beverage department                                                     |  |                                      | 3,220,355  |   |                                      |   | 3,078,288  |                                     |  |   | 9,962,929                           |   |  |   | 10,112,504 |  
|Other operating departments                                                      |  |                                      | 226,483    |   |                                      |   | 229,593    |                                     |  |   | 650,502                             |   |  |   | 671,763    |  
|Indirect                                                                         |  |                                      | 7,001,655  |   |                                      |   | 6,251,115  |                                     |  |   | 20,895,882                          |   |  |   | 19,198,447 |  
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Total hotel operating expenses                                                   |  |                                      | 13,921,616 |   |                                      |   | 12,601,171 |                                     |  |   | 41,728,726                          |   |  |   | 39,339,402 |  
|Depreciation and amortization                                                    |  |                                      | 1,797,075  |   |                                      |   | 1,227,443  |                                     |  |   | 4,777,680                           |   |  |   | 3,677,762  |  
|Corporate general and administrative                                             |  |                                      | 646,566    |   |                                      |   | 599,904    |                                     |  |   | 2,318,828                           |   |  |   | 2,362,878  |  
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Total operating expenses                                                         |  |                                      | 16,365,257 |   |                                      |   | 14,428,518 |                                     |  |   | 48,825,234                          |   |  |   | 45,380,042 |  
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|OPERATING INCOME                                                                 |  |                                      | 816,652    |   |                                      |   | 2,298,253  |                                     |  |   | 4,329,065                           |   |  |   | 7,639,837  |  
|Other income (expense)                                                           |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Interest expense                                                                 |  |                                      | (1,933,052 | ) |                                      |   | (1,047,256 | )                                   |  |   | (4,810,231                          | ) |  |   | (3,117,296 | )
|Interest income                                                                  |  |                                      | 22,318     |   |                                      |   | 32,570     |                                     |  |   | 57,141                              |   |  |   | 99,404     |  
|Impairment of note receivable                                                    |  |                                      | (100,000   | ) |                                      |   |           |                                     |  |   | (300,000                            | ) |  |   |           |  
|Equity in joint venture                                                          |  |                                      | (333,188   | ) |                                      |   | (624,039   | )                                   |  |   | 261,622                             |   |  |   | (624,039   | )
|Unrealized gain (loss) on hedging activities                                     |  |                                      | 116,016    |   |                                      |   | (329,972   | )                                   |  |   | 86,743                              |   |  |   | (56,113    | )
|Loss on disposal of assets                                                       |  |                                      | 2,010      |   |                                      |   | 4,863      |                                     |  |   | (114,962                            | ) |  |   | (9,404     | )
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Income (loss) before minority interest in operating partnership and income taxes |  |                                      | (1,409,244 | ) |                                      |   | 334,419    |                                     |  |   | (490,622                            | ) |  |   | 3,932,389  |  
|Minority interest in operating partnership                                       |  |                                      | 282,336    |   |                                      |   | (219,056   | )                                   |  |   | (181,933                            | ) |  |   | (1,369,267 | )
|Income tax benefit (provision)                                                   |  |                                      | 603,135    |   |                                      |   | 293,756    |                                     |  |   | 1,010,194                           |   |  |   | (108,694   | )
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|NET INCOME (LOSS)                                                                |  | $                                    | (523,773   | ) |                                      | $ | 409,119    |                                     |  | $ | 337,639                             |   |  | $ | 2,454,428  |  
|                                                                                 |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Net income per share                                                             |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Basic                                                                            |  | $                                    | (0.08      | ) |                                      | $ | 0.06       |                                     |  | $ | 0.05                                |   |  | $ | 0.36       |  
|Diluted                                                                          |  | $                                    | (0.08      | ) |                                      | $ | 0.06       |                                     |  | $ | 0.05                                |   |  | $ | 0.36       |  
|Weighted average number of shares outstanding                                    |  |                                      |            |   |                                      |   |            |                                     |  |   |                                     |   |  |   |            |  
|Basic                                                                            |  |                                      | 6,936,613  |   |                                      |   | 6,864,935  |                                     |  |   | 6,936,435                           |   |  |   | 6,825,786  |  
|Diluted                                                                          |  |                                      | 6,975,613  |   |                                      |   | 6,924,935  |                                     |  |   | 6,973,100                           |   |  |   | 6,885,786  |  

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



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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY

(unaudited)



|                                           |  |              |  |            |        |                 |   |            |  |   |             |   |  |   |            |  
|------------------------------------------ |  | ------------ |  | ---------- | ------ | --------------- | - | ---------- |  | - | ----------- | - |  | - | ---------- | -
|                                           |  | Common Stock |  | Additional |        | Accumulated     |   |            |  |  
|                                           |  | Shares       |  | Par Value  |        | Paid-In Capital |   | Deficit    |  |   | Total       |  
|Balances at December 31, 2007              |  | 6,897,000    |  | $          | 68,970 |                 | $ | 48,321,505 |  | $ | (8,204,032  | ) |  | $ | 40,186,443 |  
|Issuance of restricted common stock awards |  | 42,613       |  |            | 426    |                 |   | 151,270    |  |   |            |   |  |   | 151,696    |  
|Amortization of deferred stock grants      |  |             |  |            |       |                 |   | 85,500     |  |   |            |   |  |   | 85,500     |  
|Net income                                 |  |             |  |            |       |                 |   |           |  |   | 337,639     |   |  |   | 337,639    |  
|Dividends declared                         |  |             |  |            |       |                 |   |           |  |   | (3,539,203  | ) |  |   | (3,539,203 | )
|                                           |  |              |  |            |        |                 |   |            |  |   |             |   |  |   |            |  
|Balances at September 30, 2008             |  | 6,939,613    |  | $          | 69,396 |                 | $ | 48,558,275 |  | $ | (11,405,596 | ) |  | $ | 37,222,076 |  
|                                           |  |              |  |            |        |                 |   |            |  |   |             |   |  |   |            |  

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



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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)



|                                                                                  |  |                                     |             |   |                                     |   |             |  
|--------------------------------------------------------------------------------- |  | ----------------------------------- | ----------- | - | ----------------------------------- | - | ----------- | -
|                                                                                  |  | Nine months EndedSeptember 30, 2008 |             |   | Nine months endedSeptember 30, 2007 |  
|Cash flows from operating activities:                                             |  |                                     |             |   |                                     |   |             |  
|Net income                                                                        |  | $                                   | 337,639     |   |                                     | $ | 2,454,428   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                                     |             |   |                                     |   |             |  
|Depreciation and amortization                                                     |  |                                     | 4,777,680   |   |                                     |   | 3,677,762   |  
|Equity in joint venture                                                           |  |                                     | (261,622    | ) |                                     |   | 624,039     |  
|Loss on disposal of assets                                                        |  |                                     | 114,962     |   |                                     |   | 9,404       |  
|Impairment of note receivable                                                     |  |                                     | 300,000     |   |                                     |   |            |  
|Unrealized (gain) loss on hedging activities                                      |  |                                     | (86,743     | ) |                                     |   | 56,113      |  
|Amortization of deferred financing costs                                          |  |                                     | 256,002     |   |                                     |   | 207,584     |  
|Charges related to equity-based compensation                                      |  |                                     | 237,196     |   |                                     |   | 128,811     |  
|Minority interest in operating partnership                                        |  |                                     | 181,933     |   |                                     |   | 1,369,267   |  
|Changes in assets and liabilities:                                                |  |                                     |             |   |                                     |   |             |  
|Restricted cash                                                                   |  |                                     | (216,844    | ) |                                     |   | (201,636    | )
|Accounts receivable                                                               |  |                                     | 47,573      |   |                                     |   | 148,341     |  
|Inventory, prepaid expenses and other assets                                      |  |                                     | (2,399,976  | ) |                                     |   | (1,005,968  | )
|Accounts payable and other accrued liabilities                                    |  |                                     | (1,009,373  | ) |                                     |   | 1,678,235   |  
|Advance deposits                                                                  |  |                                     | 279,138     |   |                                     |   | 321,233     |  
|Due from affiliates                                                               |  |                                     | (20,680     | ) |                                     |   | 156,808     |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Net cash provided by operating activities                                         |  |                                     | 2,536,885   |   |                                     |   | 9,624,421   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|                                                                                  |  |                                    
|Cash flows from investing activities:                                             |  |                                     |             |   |                                     |   |             |  
|Acquisition of hotel properties                                                   |  |                                     | (2,063,794  | ) |                                     |   |            |  
|Improvements and additions to hotel properties                                    |  |                                     | (29,793,040 | ) |                                     |   | (11,790,221 | )
|Investment in joint venture                                                       |  |                                     | (4,743,207  | ) |                                     |   | (6,106,155  | )
|Distributions from joint venture                                                  |  |                                     | 27,362      |   |                                     |   |            |  
|Funding of restricted cash reserves                                               |  |                                     | (1,262,108  | ) |                                     |   | (855,784    | )
|Proceeds of restricted cash reserves                                              |  |                                     | 765,402     |   |                                     |   | 824,446     |  
|Proceeds of notes receivable                                                      |  |                                     |            |   |                                     |   | 4,030,000   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Net cash used in investing activities                                             |  |                                     | (37,069,385 | ) |                                     |   | (13,897,714 | )
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Cash flows from financing activities:                                             |  |                                     |             |   |                                     |   |             |  
|Dividends and distributions paid                                                  |  |                                     | (5,438,138  | ) |                                     |   | (5,420,590  | )
|Proceeds of mortgage refinancing                                                  |  |                                     | 10,707,127  |   |                                     |   | 11,851,780  |  
|Net proceeds of (payments of) credit facility                                     |  |                                     | 32,800,000  |   |                                     |   | 979,626     |  
|Payment of deferred financing costs                                               |  |                                     | (508,019    | ) |                                     |   | (500,804    | )
|Payment of loans                                                                  |  |                                     | (490,000    | ) |                                     |   | (458,879    | )
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Net cash provided by financing activities                                         |  |                                     | 37,070,970  |   |                                     |   | 6,451,133   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Net increase in cash and cash equivalents                                         |  |                                     | 2,538,470   |   |                                     |   | 2,177,840   |  
|Cash and cash equivalents at the beginning of the period                          |  |                                     | 3,988,700   |   |                                     |   | 1,445,491   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Cash and cash equivalents at the end of the period                                |  | $                                   | 6,527,170   |   |                                     | $ | 3,623,331   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|                                                                                  |  |                                    
|Supplemental disclosures:                                                         |  |                                     |             |   |                                     |   |             |  
|Cash paid during the period for interest                                          |  | $                                   | 5,487,558   |   |                                     | $ | 3,370,292   |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Cash paid during the period for income taxes                                      |  | $                                   | 158,240     |   |                                     | $ | 310,568     |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Non-cash investing and financing activities:                                      |  |                                     |             |   |                                     |   |             |  
|Assumption of existing indebtedness on purchase of hotel properties               |  | $                                   | 5,750,000   |   |                                     | $ |            |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  
|Refinance of mortgage notes                                                       |  | $                                   | 5,260,000   |   |                                     | $ | 23,148,220  |  
|                                                                                  |  |                                     |             |   |                                     |   |             |  

The accompanying notes are an integral part of these financial statements



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MHI HOSPITALITY CORPORATION

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Organization and Description of Business

MHI
Hospitality Corporation (the Company) is a self-advised real estate investment trust (REIT) that was incorporated in Maryland on August 20, 2004 to own full-service upper-upscale, upscale and mid-scale hotels located in
primary and secondary markets in the mid-Atlantic, Midwest and Southeastern regions of the United States. The hotels operate under well-known national hotel brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn.

The Company commenced operations on December 21, 2004 when it completed its initial public offering (IPO) and thereafter consummated the
acquisition of six hotel properties (initial properties). Substantially all of the Companys assets are held by, and all of its operations are conducted through, MHI Hospitality, L.P. (the Operating Partnership or the
Partnership). For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which is approximately 65.0% owned by the Company, leases its hotels to a subsidiary of MHI Hospitality TRS Holding Inc.,
MHI Hospitality TRS, LLC, (collectively, MHI TRS), a wholly owned subsidiary of the Operating Partnership. MHI TRS then engages a hotel management company to operate the hotels under a management contract. MHI TRS is treated as a taxable
REIT subsidiary for federal income tax purposes.

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

On March 29, 2007, the Company closed a $23.0 million refinancing of the mortgage on the Hilton Wilmington Riverside.
Approximately $13.8 million of the proceeds were used to satisfy the existing indebtedness. The remainder of the proceeds, approximately $9.2 million, was used to fund renovations to the property. The new mortgage matures March 29, 2017 and
bears interest at a rate of 6.21%, with payments of interest-only due for the first 24 months. Thereafter, payments of interest and principal are required under a 20-year amortization schedule.

On April 26, 2007, the Company entered into a program agreement and related operating agreements with CRP/MHI Holdings, LLC, an affiliate of Carlyle
Realty Partners V, L.P. and The Carlyle Group (Carlyle). The agreements provide for the formation of entities to be jointly owned by the Company and Carlyle, which will source, underwrite, acquire, develop and operate hotel assets and/or
hotel portfolios. Under the agreement, the Company will offer the joint venture the first right to acquire potential investment opportunities identified by the Company with total capitalization requirements in excess of $30.0 million. Carlyle has
agreed to commit up to $100.0 million of equity capital to the joint venture over a three-year period. Carlyle will fund up to 90% of the equity of an acquisition, and the Company will provide between 10% and 25%.

The Company will receive an asset management fee of 1.5% of the gross revenues of the hotels owned by the venture. In addition, the Company will have a
first right of offer with respect to any investment disposed by the joint venture. It is expected that hotels acquired by the joint venture will be managed by MHI Hotels Services, LLC (MHI Hotels Services).

On August 1, 2007, the Company entered into an amendment to its credit agreement with Branch Banking & Trust Company
(BB&T), as administrative agent and lender, dated May 8, 2006. The amended credit agreement with BB&T and certain other lenders reduced the rate of interest on the Companys revolving credit facility by 0.375%, so that
it bears a rate equal to LIBOR plus additional interest ranging from 1.625% to 2.125%. The amendment also reduced the capitalization rate to 8.5% from 10.0% for purposes of determining the asset value of the collateral for the credit facility.
Finally, the amendment extended the maturity date of the Companys revolving credit facility from May 8, 2010 to May 8, 2011.

On August 2, 2007, the Company closed a $23.0 million refinancing of the mortgage on the Hilton Savannah DeSoto. Approximately $9.6 million of the proceeds were used to satisfy the existing indebtedness and pay closing costs. At
closing, approximately $2.4 million of the proceeds were paid to the Company. The remainder of the proceeds has funded and will continue to fund renovations to the property. The new mortgage matures August 1, 2017 and bears interest at a rate
of 6.06%, with payments of interest-only due for the first 36 months. Thereafter, payments of interest and principal are required under a 20-year amortization schedule.

On August 8, 2007, through its joint venture with Carlyle, the Company completed the acquisition of the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida for $74.0
million, with Carlyle retaining a 75% equity position. A portion of the purchase was financed with a two-year $57,600,000 non-recourse loan from Société Générale. The loan has two one-year extensions and is interest-only
bearing a rate of LIBOR plus 1.94%. The hotel is managed by MHI Hotels Services.

On October 29, 2007, the Company purchased a
250-room hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, for approximately $13.8 million, including transfer costs. The hotel is located in Tampas Westshore corridor and is within two



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miles of the Tampa International Airport. The Company is making extensive renovations and expects to re-open the hotel as the Crowne Plaza Tampa Westshore,
as is consistent with the Companys repositioning strategy, in the first quarter of 2009. The Company financed the acquisition and is financing the renovations with funds drawn on its credit facility.

On April 15, 2008, the Company entered into a second amendment to its credit agreement modifying certain provisions of the agreement including
increases in the lenders revolver commitments by $20.0 million thereby enabling the Company to borrow up to $80.0 million.

On
April 24, 2008, the Company purchased the 172-room Hampton Marina Hotel in Hampton, Virginia for approximately $7.8 million, including transfer costs. To facilitate the purchase, a subsidiary of the Company assumed $5.75 million of existing
indebtedness. The Company has commenced significant renovations to re-brand the hotel as is consistent with the Companys repositioning strategy. On October 7, 2008, the Company completed the hotels conversion to the Crowne Plaza
Hampton Marina.

On June 13, 2008, through its joint venture with Carlyle, the Company closed on a restructuring of the mortgage on
the Crowne Plaza Hollywood Beach Resort whereby the joint venture, in which Carlyle maintains a 75.0% equity interest, purchased a $22.0 million junior participation in the existing mortgage for $19.0 million. The mortgage note was restructured so
that the first $35.6 million of indebtedness bears a rate of LIBOR plus 0.98%. The Company funded its portion of the purchase of the junior participation with funds drawn on its credit facility.

On June 30, 2008, the Company closed a $9.0 million refinancing of the existing indebtedness on the property in Hampton, Virginia. At closing, the
Company paid approximately $0.5 million and accessed approximately $5.5 million of the proceeds in order to retire the existing indebtedness and pay closing costs. The remainder of the proceeds, approximately $3.5 million, has funded and will
continue to fund a product improvement plan for the hotel in connection with the Crowne Plaza licensing. The new mortgage matures June 30, 2011 and bears a rate of LIBOR plus 2.75% during the construction period and LIBOR plus 2.50% thereafter,
payable monthly during the term. The loan can be extended for one 12-month period.

2. Summary of Significant Accounting Policies

Basis of Presentation The consolidated financial statements of the Company presented herein include all of the accounts of MHI Hospitality
Corporation as of and for the three months and nine months ended September 30, 2008 and 2007.

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

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

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 agreements with MONY Life Insurance Company (MONY), which holds mortgages on the Hilton Wilmington Riverside and the Hilton Savannah DeSoto; PNC Bank,
trustee for the mortgage holder on the Crowne Plaza Jacksonville Hotel; and TowneBank, which holds the mortgage on the Crowne Plaza Hampton Marina.

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

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

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



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Properties Under Development Investments in hotel property that have been taken out of
service for an extensive renovation in anticipation of re-opening under a new brand are included in properties under development. As of September 30, 2008 and December 31, 2007, there were one property and two properties, respectively,
under development; one, in Jeffersonville, Indiana, which re-opened on May 1, 2008 as the Sheraton Louisville Riverside, and one in Tampa, Florida which is expected to re-open in the first quarter of 2009 as the Crowne Plaza Tampa Westshore.

For properties under development, interest and real estate taxes incurred during the renovation period are capitalized and depreciated
over the lives of the renovated assets. Capitalized interest for the three months and nine months ended September 30, 2008 was $287,916 and $1,212,576, respectively, and $214,549 and $562,572 for the three months and nine months ended
September 30, 2007, respectively.

Investment in Joint Venture  Investment in joint venture represents the Companys
non-controlling indirect 25.0% equity interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel under a management contract;
and (iii) the entity that owns the $22.0 million junior participation in the existing mortgage. Carlyle owns a 75.0% controlling indirect interest in all these entities. The Company accounts for its investment in the joint venture under the
equity method of accounting and is entitled to receive its pro rata share of annual cash flow. The Company also has the opportunity to earn an incentive participation in net sale proceeds based upon the achievement of certain overall investment
returns, in addition to its pro rata share of net sale proceeds.

Derivative Instruments  The Company accounts for derivative
instruments in accordance with the provisions of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (SFAS 133). Under SFAS 133, all
derivative instruments are required to be reflected as assets or liabilities on the balance sheet and measured at fair value. Derivative instruments used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment
attributable to a particular risk, such as an interest rate risk, are considered fair value hedges. Derivative instruments used to hedge exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered
cash flow hedges. For a derivative instrument designated as a cash flow hedge, the change in fair value each period is reported in accumulated other comprehensive income in stockholders equity to the extent the hedge is effective. For a
derivative instrument designated as a fair value hedge, the change in fair value each period is reported in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. For a derivative instrument that does
not qualify for hedge accounting or is not designated as a hedge, the change in fair value each period is reported in earnings. The Company does not enter into derivative instruments for speculative trading purposes.

At September 30, 2008 and December 31, 2007, the Companys interest-rate swap agreement had an estimated fair value of $(1,093,751) and
$(1,180,494), respectively, and is included in accounts payable and other accrued liabilities.

Franchise License Fees Fees
expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The un-amortized franchise fees as of September 30, 2008 and December 31, 2007 were $370,290 and $347,862, respectively. Amortization
expense for the three months and nine months ended September 30, 2008 totaled $9,356 and $27,020, respectively, and $6,238 and $18,713 for the three months and nine months ended September 30, 2007, respectively.

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

On March 1,
2007, two holders of units in the Operating Partnership redeemed 120,000 units for an equivalent number of shares of the Companys common stock. On August 28, 2007, one holder redeemed 50,000 units for an equivalent number of shares as
well.



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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.

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

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

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

The Company accounts for income taxes 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.

The Company adopted the provisions of FASB Interpretation No. 48 (FIN 48), Accounting
for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FAS 109), on January 1, 2007. As a result of the implementation of FIN 48, the Corporation recognized no material adjustments regarding its
tax accounting treatment. The Corporation expects to recognize interest and penalties related to uncertain tax positions, if any, as income tax expense.

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

Under the Plan, the Company has made restricted stock and deferred stock awards totaling 105,613 shares including 60,000 shares granted under a deferred stock award to its Chief Operating Officer, 25,613 restricted
shares issued to certain executives and employees, and 20,000 restricted shares issued to its directors. The 60,000 shares granted under the deferred stock award vest over five years. Of the 60,000 shares granted to the Companys Chief
Operating Officer, only 10,000 shares have vested; another 14,000 shares were issued January 14, 2008, but do not vest until January 1, 2011. The 25,613 restricted shares issued to certain of the Companys executives and employees
have all vested. Regarding the restricted shares awarded to the Companys directors, the shares vest at the end of the year of service for which the shares are awarded.

The value of the awards is charged to compensation expense on a straight-line basis over the vesting or service period based on the Companys stock
price on the date of grant or issuance. Under the Plan, the Company may issue a variety of performance-based stock awards, including nonqualified stock options. As of September 30, 2008, no performance-based stock awards have been granted.
Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value method. Total compensation cost recognized under the Plan was $40,725 and $122,175 for the three months and nine months
ended September 30, 2008, respectively, and $45,549 and $128,811 for the three months and nine months ended September 30, 2007, respectively.

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

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

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

Reclassifications  Certain reclassifications have been made to the prior period balances to conform to the current period presentation. Such
reclassifications had no effect on the previously reported net assets.



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Recent Account Pronouncements On September 15, 2006, the FASB issued SFAS
No. 157, Fair Value Measurements (SFAS 157). SFAS 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to current practice resulting from the application of
SFAS 157 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS 157 was originally effective for fiscal years beginning after November 15, 2007 and
interim periods within those fiscal years, but was amended on February 6, 2008 to defer the effective date for one year for certain non-financial assets and liabilities. The Company adopted SFAS 157 on January 1, 2008, which had no
material impact on its financial statements.

SFAS 157 defines fair value as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at the measurement date (exit price). SFAS 157 classifies the inputs used to measure fair value into the following hierarchy:



|Level 1 | Unadjusted quoted prices in active markets for identical assets or liabilities
|------- | ------------------------------------------------------------------------------



|Level 2 | Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not
active, or Inputs other than quoted prices that are observable for the asset or liability
|------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|Level 3 | Unobservable inputs for the asset or liability
|------- | ----------------------------------------------

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

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS
159). SFAS 159 is effective for fiscal years beginning after November 15, 2007. SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value that are not otherwise
required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that items fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes
presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. The Company adopted SFAS 159 on January 1, 2008, which had no material impact
on its consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R Business Combinations
(SFAS 141(R)). SFAS 141(R) establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling
interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination, recognizing assets acquired and liabilities assumed arising from contingencies, and determining what
information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for acquisitions consummated in fiscal years beginning after December 15,
2008. The Company expects SFAS 141(R) will have an impact on its consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions the Company
consummates after the effective date.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements (SFAS 160). SFAS 160 changes the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. This new
consolidation method significantly changes the accounting for transactions with minority interest holders. SFAS 160 is effective for fiscal years beginning after December 15, 2008 with early application prohibited. The Company is currently
evaluating what impact SFAS 160 will have on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161,
Disclosures about Derivative Instruments and Hedging Activities(SFAS 161). SFAS 161 requires expanded disclosures regarding the location and amounts of derivative instruments in an entitys financial statements, how
derivative instruments and related hedged items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and how derivative instruments and related hedged items affect an entitys financial
position, operating results and cash flows. SFAS 161 is effective for periods beginning on or after November 15, 2008. The Company is currently evaluating what impact SFAS 161 will have on its consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position No. 142-3, Determination of the Useful Life of Intangible Assets(FSP 142-3)
to improve the consistency between the useful life of a recognized intangible asset (under SFAS 142) and the period of expected cash flows used to measure the fair value of the intangible asset (under SFAS 141(R)). FSP 142-3 amends the factors to be
considered when developing renewal or extension assumptions that are used to estimate an intangible assets life under SFAS 142. The guidance in the new staff position is to be applied progressively to intangible assets acquired after
December 31, 2008. In addition, FSP No. 142-3 increases the disclosure requirements related to renewal or extension assumptions. The Company is currently evaluating the impact of FSP 142-3 on its consolidated financial statements.



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In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting
Principles(SFAS 162). SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United States (the GAAP hierarchy). SFAS 162 is effective 60 days following the SECs approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The Company is currently evaluating the impact of the SFAS 162 on its consolidated financial statements.

3. Acquisition of Hotel Properties

On April 24,
2008, the Company acquired the 172-room Crowne Plaza Hampton Marina (formerly, the Hampton Marina Hotel) in Hampton, Virginia for approximately $7.8 million, including transfer costs. To facilitate the purchase, a subsidiary of the Company assumed
$5.75 million of existing indebtedness. The allocation of the purchase price, including transfer costs, based on their fair values was as follows (in thousands):



|                                  |  |   |      
|--------------------------------- |  | - | -----
|Land and land improvements        |  | $ | 1,055
|Buildings and improvements        |  |   | 6,697
|Furniture, fixtures and equipment |  |   | 50   
|                                  |  |   |      
|                                  |  | $ | 7,802
|                                  |  |   |      

The results of operations are included in the Companys consolidated statements of operations
from the date of acquisition of this hotel. The following pro forma financial information presents the results of operations of the Company for the nine months ended September 30, 2008 and 2007 as if the purchase of the property in Hampton,
Virginia had taken place on January 1, 2007. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually occurred had the transaction taken
place on January 1, 2007, or of future results of operations (in thousands, except per share date):



|                             |  |                    |            |                    |   |           
|---------------------------- |  | ------------------ | ---------- | ------------------ | - | ----------
|                             |  | September 30, 2008 |            | September 30, 2007
|                             |  | (unaudited)        |            | (unaudited)       
|Pro forma revenues           |  | $                  | 53,997,838 |                    | $ | 56,581,486
|Pro forma operating expenses |  |                    | 50,151,064 |                    |   | 48,939,128
|Pro forma operating income   |  |                    | 3,846,774  |                    |   | 7,642,358 
|Pro forma net income         |  |                    | 88,830     |                    |   | 2,375,616 
|Pro forma earnings per share |  |                    | 0.01       |                    |   | 0.35      
|Pro forma common shares      |  |                    | 6,935      |                    |   | 6,826     

4. Investment in Hotel Properties

Investment in hotel properties as of September 30, 2008 and December 31, 2007 consisted of the following (in thousands):



|                                  |  |                    |         |   |                   |   |         |  
|--------------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------- | -
|                                  |  | September 30, 2008 |         |   | December 31, 2007 |  
|                                  |  | (unaudited)        |         |   |                   |  
|Land and land improvements        |  | $                  | 14,715  |   |                   | $ | 12,586  |  
|Buildings and improvements        |  |                    | 141,088 |   |                   |   | 101,205 |  
|Furniture, fixtures and equipment |  |                    | 24,677  |   |                   |   | 19,470  |  
|                                  |  |                    |         |   |                   |   |         |  
|                                  |  |                    | 180,480 |   |                   |   | 133,261 |  
|Less: accumulated depreciation    |  |                    | (28,151 | ) |                   |   | (23,830 | )
|                                  |  |                    |         |   |                   |   |         |  
|                                  |  | $                  | 152,329 |   |                   | $ | 109,431 |  
|                                  |  |                    |         |   |                   |   |         |  

5. Credit Facility

As of September 30, 2008, the Company had a secured, revolving credit facility with a syndicated bank group comprised of BB&T, Key Bank National Association and Manufacturers and Traders Trust Company that
enables the Company to borrow up to $80.0 million, subject to borrowing base and loan-to-value limitations. The credit facility was established during the second quarter of 2006 and replaced a $23.0 million secured, revolving credit facility with
BB&T. On August 1, 2007, the Company entered into an amendment to its credit agreement reducing the rate of interest on the credit facility by 0.375%, reducing the capitalization rate to 8.5% from 10.0% for purposes of determining the asset
value of the collateral for the credit facility and extending the maturity date by one year. On April 15, 2008, the Company entered into a second amendment to its credit agreement modifying certain provisions of the agreement including
increases in the lenders revolver commitments by $20.0 million, thereby enabling the Company to borrow up to $80.0 million. The Company had borrowings of approximately $67.2 million and approximately $34.4 million at September 30, 2008
and December 31, 2007, respectively.



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The facility matures during May 2011 and bears interest at a floating rate of LIBOR plus additional
interest ranging from 1.625% to 2.125%. On September 30, 2008, LIBOR was 3.926%. In some circumstances, the revolving line of credit facility may bear interest at BB&Ts prime rate. Any amounts drawn under the revolving line of credit
facility mature at the expiration of the facility. The Company is required to pay a fee of 0.25% on the unused portion of the credit facility. Under the terms of the agreement, the Company was required to purchase an interest rate swap in order to
hedge against interest rate risk.

The facility is secured by the Holiday Inn Brownstone in Raleigh, North Carolina, the Hilton
Philadelphia Airport, the Sheraton Louisville Riverside and the property under renovation in Tampa, Florida, as well as a lien on all business assets of those properties including, but not limited to, equipment, accounts receivable, inventory,
furniture, fixtures and proceeds thereof. At September 30, 2008, the four properties had a net carrying value of approximately $80.9 million. Under the terms of the credit facility, the Company must satisfy certain financial and non-financial
covenants. As of September 30, 2008 and December 31, 2007, the Company was in compliance with all of the required covenants.

6. Mortgage Debt

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

On June 30, 2008, the Company closed a $9.0 million refinancing of the mortgage on the property in Hampton, Virginia. Approximately
$5.5 million of the proceeds were used to satisfy the existing indebtedness and pay closing costs. The remaining portion of the proceeds totaling approximately $3.5 million has funded and will continue to fund a product improvement plan for the
hotel in connection with its Crowne Plaza licensing. The new mortgage matures June 30, 2011 and may be extended for one 12-month period. Monthly payments of interest at a rate of LIBOR plus 2.75% during the construction period and LIBOR plus
2.50% thereafter are required under the loan. The outstanding balance due on the loan as of September 30, 2008 was approximately $7.0 million.

On August 2, 2007, the Company closed a $23.0 million refinancing of the mortgage on the Hilton Savannah DeSoto. Approximately $9.6 million of the proceeds were used to satisfy the existing indebtedness and pay closing costs. At
closing, approximately $2.4 million of the proceeds were paid to the Company. The remaining $11.0 million of the proceeds has funded and will continue to fund a product improvement plan for the hotel in connection with the Hilton relicensing. The
new mortgage matures August 1, 2017 and bears interest at a rate of 6.06%, with payments of interest-only due for the first 36 months. Thereafter, payments of interest and principal are required under a 25-year amortization schedule. The
outstanding balance due on the loan as of September 30, 2008 and December 31, 2007 was $23.0 million and $14.0 million, respectively.

On March 29, 2007, the Company closed a $23.0 million refinancing of the mortgage on the Hilton Wilmington Riverside. Approximately $13.8 million of the proceeds were used to satisfy the existing indebtedness. The remainder of the
proceeds, approximately $9.2 million, was used to fund renovations to the property. The new mortgage matures March 29, 2017 and bears interest at a rate of 6.21% with payments of interest-only due for the first 24 months. Thereafter, payments
of interest and principal are required under a 25-year amortization schedule. The outstanding balance due on the loan as of September 30, 2008 and December 31, 2007 was $23.0 million.

On July 22, 2005, the Company purchased the Crowne Plaza Jacksonville Hotel in Jacksonville, Florida from BIT Holdings Seventeen, Inc., an affiliate
of the AFL-CIO Building Investment Trust (the Trust), for an aggregate price of $22.0 million. The Trust, for which PNC Bank acts as trustee, financed a portion of the purchase price by extending an $18.0 million mortgage loan (the
Loan) to the purchaser. The Loan, which is secured by a lien against all the assets, rents and profits of the hotel as well as the real property, bears interest at the rate of 8.0% payable monthly during the term and matures in July
2010. Pre-payment penalties apply toward any principal of the loan repaid before the fifth year of the term.

Total mortgage debt
maturities as of September 30, 2008 for the following twelve-month periods were as follows ($000s):



|                                                                              |  |   |        |  
|----------------------------------------------------------------------------- |  | - | ------ | -
|September 30, 2009                                                            |  | $ | 162    |  
|September 30, 2010                                                            |  |   | 18,473 |  
|September 30, 2011                                                            |  |   | 9,843  |  
|September 30, 2012                                                            |  |   | 896    |  
|September 30, 2013                                                            |  |   | 953    |  
|Thereafter                                                                    |  |   | 42,673 |  
|                                                                              |  |   |        |  
|Total future maturities                                                       |  | $ | 73,000 |  
|Less: Funds remaining to be drawn on the Crowne Plaza Hampton Marina mortgage |  |   | (2,033 | )
|                                                                              |  |   |        |  
|Mortgage loan balance, September 30, 2008                                     |  | $ | 70,967 |  
|                                                                              |  |   |        |  

7. Commitments and Contingencies

Ground, Building and Submerged Land Leases  The Company leases 2,086 square feet of commercial space next to the Savannah hotel property for
use as an office, retail or conference space, or for any related or ancillary purposes for the hotel and/or



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atrium space. In December 2007, the Company signed an amendment to the lease to include rights to the outdoor esplanade adjacent to the leased commercial
space. The areas are leased under a six-year operating lease, which expired October 31, 2006 and has been renewed for the first of three optional five-year periods expiring October 31, 2011, October 31, 2016 and October 31, 2021,
respectively. Rent expense for the three months and nine months ended September 30, 2008 for this operating lease was $18,835 and $47,425, respectively, and $10,795 and $32,385 for the three months and nine months ended September 30, 2007,
respectively.

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

The
Company leases a parking lot adjacent to the Holiday Inn Brownstone in Raleigh, North Carolina. The land is leased under a second amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a
50-year operating lease, which expires August 31, 2016. There is a renewal option for up to three additional ten-year periods expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. The Company holds an
exclusive and irrevocable option to purchase the leased land at fair market value at the end of the original lease term, subject to the payment of an annual fee of $9,000, and other conditions. Rent expense for the three months and nine months ended
September 30, 2008 was $23,871 and $71,612, respectively, and $23,871 and $71,612 for the three months and nine months ended September 30, 2007, respectively.

In conjunction with the sublease arrangement for the property at Shell Island, the Company incurs an annual lease expense for a leasehold interest other than the purchased leasehold interest. Lease expense was $42,034
and $126,103 for the three months and nine months ended September 30, 2008, respectively, and $49,289 and $147,853 for the three months and nine months ended September 30, 2007, respectively.

The Company leases certain submerged land in the Saint Johns River in front of the Crowne Plaza Jacksonville Hotel from the Board of Trustees of the
Internal Improvement Trust Fund of the State of Florida. The submerged land is leased under a five-year operating lease, which expires September 18, 2012 requiring annual payments of $4,961. Rent expense for the three months and nine months
ended September 30, 2008 was $1,240 and $3,720, respectively, and $1,160 and $3,480 for the three months and nine months ended September 30, 2007, respectively.

The Company leases 1,890 square feet of commercial office space in Williamsburg, Virginia under a two-year agreement that expired August 31, 2008 and which has been renewed for an additional year. Rent expense
for the three months and nine months ended September 30, 2008 was $10,814 and $32,228, respectively, and $10,499 and $31,289 for the three months and nine months ended September 30, 2007, respectively.

The Company has agreed to lease a parking lot in close proximity to the Sheraton Louisville Riverside. The land is leased under an agreement dated
August 17, 2007 with the City of Jeffersonville, which in turn leases the property from the State of Indiana. The lease term for the parking lot coincides with that of the lease with the State of Indiana, which expires December 31, 2011.
The Company has the right to renew or extend its lease with the City of Jeffersonville pursuant to the conditions of the original lease provided that the City of Jeffersonville is able to renew or extend the underlying lease with the State of
Indiana. Rent expense for the three months and nine months ended September 30, 2008 was $8,400 and $14,000, respectively.

Management Agreement  Each of the operating hotels that the Company owned at September 30, 2008 operates under a ten-year master management agreement with MHI Hotels Services, which expires between December 2014 and April
2018 (see Note 9).

Franchise Agreements  As of September 30, 2008, the Companys hotels, except for the property
under development, operate under franchise licenses from national hotel companies. A franchise license has been obtained for the Crowne Plaza Tampa Westshore, expected to re-open in the first quarter 2009. 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  Each month, the Company is required to escrow with its
lender on the Wilmington Riverside Hilton and the Savannah DeSoto Hilton an amount equal to1/12 of the annual real estate taxes due for the properties. The Company is also required to establish a property improvement fund for each of these two hotels to cover the cost of
replacing capital assets at the properties. Each month, contributions to the property improvement fund equal to 4.0% of gross revenues for the Savannah DeSoto Hilton and the Wilmington Riverside Hilton.

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

Pursuant to the terms of the mortgage on the Crowne Plaza Hampton Marina, the Company was
required to contribute $275,000 to an operating reserve. Upon meeting certain debt service coverage requirements, the reserve will be liquidated. In addition, the Company must establish a property improvement fund in January 2010 into which it will
be required to make monthly contributions equal to 4.0% of gross revenues.



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##### Table of Contents

Litigation  The Company is not involved in any legal proceedings other than routine legal
proceedings accruing in the ordinary course of business. The Company believes that these routine legal proceedings, in the aggregate, are not material to the Companys financial condition or results of operation.

8. Capital Stock

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

In January 2007, the Company issued 13,500 shares of restricted stock to certain executives and independent directors. In March 2007, two holders of
units in the Operating Partnership redeemed 120,000 units for an equivalent number of shares of the Companys common stock. In April 2007, the Company issued 1,500 shares of restricted stock to a new independent director. In August 2007, one
holder of units in the Operating Partnership redeemed 50,000 units for an equivalent number of shares of the Companys common stock. On January 1, 2008 and January 14, 2008, the Company issued 10,000 non-restricted shares and 14,000
restricted shares, respectively to its Chief Operating Officer in accordance with the terms of his employment contract, as amended. On February 6, 2008, the Company issued 18,613 shares of restricted stock to certain executives and independent
directors. As of September 30, 2008 and December 31, 2007, the Company had 6,939,613 and 6,897,000 shares of common stock outstanding, respectively.

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

Preferred Shares  The Company is authorized to issue 1,000,000 shares of preferred stock, $.01 par value per share. As of September 30, 2008, there were no shares of preferred stock outstanding.

Operating Partnership Units  Holders of Operating Partnership units have certain redemption rights, which enable them to cause the Operating
Partnership to redeem their units in exchange for shares of the Companys common stock on a one-for-one basis or, at the option of the Company, cash per unit equal to the market price of the Companys common stock at the time of
redemption. The number of shares issuable upon exercise of the redemption rights will be adjusted upon the occurrence of stock splits, mergers, consolidations or similar pro-rata share transactions, which otherwise would have the effect of diluting
the ownership interests of the limited partners or the stockholders of the Company. As of September 30, 2008, the total number of Operating Partnership units outstanding was 3,737,607 with a fair market value of $19.6 million based on the price
per share of our common stock on that date.

9. Related Party Transactions

The following is a summary of the transactions between the Company and MHI Hotels Services (a company that is majority-owned and controlled by the
Companys CEO, its CFO and two members of its Board of Directors):

Accounts Receivable At September 30, 2008 and
December 31, 2007, the Company was due $32,494 and $11,814, respectively, from MHI Hotels Services.

Shell Island Sublease
 The Company has a sublease arrangement with MHI Hotels Services on its leasehold interests in the property at Shell Island. Leasehold revenue for the three months and nine months ended September 30, 2008 was $160,000 and $480,000,
respectively, and $160,000 and $480,000 for the three months and nine months ended September 30, 2007, respectively.

Sublease of
Office Space The Company subleases office space in Greenbelt, Maryland from MHI Hotels Services. Rent expense was $9,510 and $28,530 for the three months and nine months ended September 30, 2008, respectively, and $9,510 and $28,530
for the three months and nine months ended September 30, 2007, respectively.



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

Management Agreements Each of the operating hotels that the Company owned at September 30, 2008 is managed by MHI Hotels Services
under a master management agreement. The master management agreement expires between December 2014 and April 2018. MHI Hotels Services receives a base management fee, and if the hotels meet and exceed certain thresholds, an additional incentive
management fee. Pursuant to the sale of the Holiday Inn Downtown in Williamsburg, Virginia, one of the hotels initially contributed to the Company upon its formation, MHI Hotels Services has agreed to substitute the Sheraton Louisville Riverside for
the Williamsburg property under the master management agreement.

The base management fee for the initial portfolio of six hotels, which
now includes the Sheraton Louisville Riverside, was 2.0% in 2005, rising to 2.5% in 2006 and 3.0% thereafter of total gross revenues from the hotels. The base management fee for the Crowne Plaza Jacksonville Hotel was 2.0% through 2006, rising to
2.5% in 2007 and 3.0% thereafter. The base management fee for the Crowne Plaza Hampton Marina is 2.0% through 2009, 2.5% in 2010 and 3.0% thereafter. The incentive management fee, if any, will be due annually in arrears within 90 days of the end of
the fiscal year and will be equal to 10% of the amount by which the gross operating profit of the hotels, on an aggregate basis, for a given year exceeds the gross operating profit for the same hotels, on an aggregate basis, for the prior year. The
incentive management fee may not exceed 0.25% of gross revenue of all the hotels included in the incentive fee calculation.

Management
fees paid by the Company to MHI Hotels Services were $518,768 and $1,558,220 for the three months and nine months ended September 30, 2008 and $482,605 and $1,530,362 for the three months and nine months ended September 30, 2007,
respectively. In addition, no estimated incentive management fees were accrued for the three months and nine months ended September 30, 2008, and $40,283 and $131,003 were accrued for the three months and nine months ended September 30,
2007, respectively.

Employee Medical Benefits The Company purchases employee medical benefits through Maryland Hospitality,
Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. Premiums for employee medical benefits paid by the Company were $429,241 and $1,291,715 for the three months and nine months ended September 30, 2008, respectively, and $380,276 and
$1,217,286 for the three months and nine months ended September 30, 2007, respectively.

Construction Management Services
 The Company engaged MHI Hotels Services to manage the renovations of the Crowne Plaza Jacksonville, the Hilton Wilmington Riverside and the Sheraton Louisville Riverside. Construction management fees were $0 for the three months and nine
months ended September 30, 2008 and $50,000 and $500,000 for the three months and nine months ended September 30, 2007, respectively.

Charter Vessel Rental  The Company leased the Jacksonville Princess, a charter vessel docked adjacent to the Crowne Plaza Jacksonville from MHI Hotels, Inc., an affiliate of MHI Hotels Services on an event-by-event
basis for guests of the hotel. There were no charter rentals for the three months and nine months ended September 30, 2008. Charter rentals for the three months and nine months ended September 30, 2007 were $0 and $66,145, respectively.
Beginning June 1, 2007, the Company no longer charters the Jacksonville Princess from MHI Hotels, Inc., but sold catering service to MHI Hotels, Inc. for events on the charter vessel. For the three months and nine months ended
September 30, 2008, as well as for the three months and nine months ended September 30, 2007, total sales of catering services to MHI Hotels, Inc. were $0.

10. Retirement Plan

The Company began a 401(k) plan for qualified employees on April 1, 2006.
The plan is subject to safe harbor provisions which require that the Company match 100% of the first 3% of employee contributions and 50% of the next 2% of employee contributions. All Company matching funds vest immediately in accordance
with the safe harbor provision. Company contributions to the plan for the three months and nine months ended September 30, 2008 were $8,894 and $38,275, respectively, and $14,826 and $32,275 for the three months and nine months
ended September 30, 2007, respectively.



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11. Unconsolidated Joint Venture

The Company owns a 25% indirect interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel
under a management contract; and (iii) the entity that owns the junior participation in the existing mortgage. Carlyle owns a 75.0% indirect controlling interest in all these entities. The joint venture purchased the property on August 8,
2007 and began operations on September 18, 2007. Summarized financial information for this investment, which is accounted for under the equity method, is as follows:



|                                               |  |                    |           
|---------------------------------------------- |  | ------------------ | ----------
|                                               |  | September 30, 2008
|                                               |  | (unaudited)       
|ASSETS                                         |  |                    |           
|Investment in hotel properties, net            |  | $                  | 74,814,648
|Cash and cash equivalents                      |  |                    | 1,674,717 
|Restricted cash                                |  |                    | 1,021,416 
|Accounts receivable                            |  |                    | 363,555   
|Prepaid expenses, inventory and other assets   |  |                    | 1,511,383 
|                                               |  |                    |           
|TOTAL ASSETS                                   |  | $                  | 79,385,719
|                                               |  |                    |           
|                                               | 
|LIABILITIES                                    |  |                    |           
|Mortgage loans                                 |  | $                  | 35,600,000
|Accounts payable and other accrued liabilities |  |                    | 1,334,231 
|Advance deposits                               |  |                    | 209,436   
|                                               |  |                    |           
|TOTAL LIABILITIES                              |  |                    | 37,143,667
|TOTAL MEMBERS EQUITY                          |  |                    | 42,242,052
|                                               |  |                    |           
|TOTAL LIABILITIES AND MEMBERS EQUITY          |  | $                  | 79,385,719
|                                               |  |                    |           



|                                |  |                                      |            |   |                                     |   |            |  
|------------------------------- |  | ------------------------------------ | ---------- | - | ----------------------------------- | - | ---------- | -
|                                |  | Three Months EndedSeptember 30,
2008 |            |   | Nine Months EndedSeptember 30,
2008 |  
|                                |  | (unaudited)                          |            |   | (unaudited)                         |  
|Revenue                         |  |                                      |            |   |                                     |   |            |  
|Rooms department                |  | $                                    | 1,785,268  |   |                                     | $ | 7,750,367  |  
|Food and beverage department    |  |                                      | 355,284    |   |                                     |   | 1,329,580  |  
|Other operating departments     |  |                                      | 205,030    |   |                                     |   | 951,951    |  
|                                |  |                                      |            |   |                                     |   |            |  
|Total revenue                   |  |                                      | 2,345,582  |   |                                     |   | 10,031,898 |  
|Expenses                        |  |                                      |            |   |                                     |   |            |  
|Hotel operating expenses        |  |                                      |            |   |                                     |   |            |  
|Rooms department                |  |                                      | 520,954    |   |                                     |   | 1,758,986  |  
|Food and beverage department    |  |                                      | 452,405    |   |                                     |   | 1,408,165  |  
|Other operating departments     |  |                                      | 135,626    |   |                                     |   | 386,990    |  
|Indirect                        |  |                                      | 1,631,583  |   |                                     |   | 4,774,261  |  
|                                |  |                                      |            |   |                                     |   |            |  
|Total hotel operating expenses  |  |                                      | 2,740,568  |   |                                     |   | 8,328,402  |  
|Depreciation and amortization   |  |                                      | 545,726    |   |                                     |   | 1,636,544  |  
|General and administrative      |  |                                      | 1,118      |   |                                     |   | 68,949     |  
|                                |  |                                      |            |   |                                     |   |            |  
|Total operating expenses        |  |                                      | 3,287,412  |   |                                     |   | 10,033,895 |  
|                                |  |                                      |            |   |                                     |   |            |  
|Operating (loss)                |  |                                      | (941,830   | ) |                                     |   | (1,997     | )
|Gain on extinguishments of debt |  |                                      |           |   |                                     |   | 3,000,000  |  
|Interest expense                |  |                                      | (395,792   | ) |                                     |   | (1,971,732 | )
|Interest income                 |  |                                      | 4,875      |   |                                     |   | 20,219     |  
|                                |  |                                      |            |   |                                     |   |            |  
|Net income (loss)               |  | $                                    | (1,332,747 | ) |                                     | $ | 1,046,490  |  
|                                |  |                                      |            |   |                                     |   |            |  



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##### Table of Contents

12. Income Taxes

The components of the income tax provision (benefit) for the three months and nine months ended September 30, 2008 and 2007 are as follows (in thousands):



|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|--------- |  | ------------------------------------ | ---- | - | ------------------------------------ | - | ---- | ----------------------------------- |  | - | ----------------------------------- | - |  | - | ---
|          |  | Three Months EndedSeptember 30,
2008 |      |   | Three Months EndedSeptember 30,
2007 |   |      | Nine Months EndedSeptember 30,
2008 |  |   | Nine Months EndedSeptember 30,
2007
|          |  | (unaudited)                          |      |   | (unaudited)                          |   |      | (unaudited)                         |  |   | (unaudited)                        
|Current:  |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|Federal   |  | $                                    |     |   |                                      | $ |     |                                     |  | $ |                                    |   |  | $ |   
|State     |  |                                      | 10   |   |                                      |   | 31   |                                     |  |   | 153                                 |   |  |   | 57 
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|          |  |                                      | 10   |   |                                      |   | 31   |                                     |  |   | 153                                 |   |  |   | 57 
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|Deferred: |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|Federal   |  |                                      | (514 | ) |                                      |   | (272 | )                                   |  |   | (976                                | ) |  |   | 27 
|State     |  |                                      | (99  | ) |                                      |   | (53  | )                                   |  |   | (187                                | ) |  |   | 25 
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|          |  |                                      | (613 | ) |                                      |   | (325 | )                                   |  |   | (1,163                              | ) |  |   | 52 
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    
|          |  | $                                    | (603 | ) |                                      | $ | (294 | )                                   |  | $ | (1,010                              | ) |  | $ | 109
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |    

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



|                                     |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |        |  
|------------------------------------ |  | ------------------------------------ | ---- | - | ------------------------------------ | - | ---- | ----------------------------------- |  | - | ----------------------------------- | - |  | - | ------ | -
|                                     |  | Three Months EndedSeptember 30,
2008 |      |   | Three Months EndedSeptember 30,
2007 |   |      | Nine Months EndedSeptember 30,
2008 |  |   | Nine Months EndedSeptember 30,
2007 |  
|                                     |  | (unaudited)                          |      |   | (unaudited)                          |   |      | (unaudited)                         |  |   | (unaudited)                         |  
|Statutory federal income tax expense |  | $                                    | (479 | ) |                                      | $ | 114  |                                     |  | $ | (167                                | ) |  | $ | 1,337  |  
|Effect of non-taxable REIT income    |  |                                      | (35  | ) |                                      |   | (386 | )                                   |  |   | (809                                | ) |  |   | (1,310 | )
|State income tax expense             |  |                                      | (89  | ) |                                      |   | (22  | )                                   |  |   | (34                                 | ) |  |   | 82     |  
|                                     |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |        |  
|                                     |  | $                                    | (603 | ) |                                      | $ | (294 | )                                   |  | $ | (1,010                              | ) |  | $ | 109    |  
|                                     |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |        |  

As of September 30, 2008, the Company had a net deferred tax asset of approximately $2.5
million; primarily due to current and past years net operating losses. These loss carryforwards will begin to expire in 2024 if not utilized by then. The Company believes that it is more likely than not that the deferred tax asset will be
realized and that no valuation allowance is required.

13. Earnings per Share

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



|                                                          |  |                                      |           |   |                                      |   |                                     |  |                                     |           |  |   |          
|--------------------------------------------------------- |  | ------------------------------------ | --------- | - | ------------------------------------ | - | ----------------------------------- |  | ----------------------------------- | --------- |  | - | ---------
|                                                          |  | Three months endedSeptember 30,
2008 |           |   | Three months endedSeptember 30,
2007 |   | Nine months endedSeptember 30, 2008 |  | Nine months endedSeptember 30, 2007
|                                                          |  | (unaudited)                          |           |   | (unaudited)                          |   | (unaudited)                         |  | (unaudited)                        
|Net income (loss)                                         |  | $                                    | (523,773  | ) |                                      | $ | 409,119                             |  | $                                   | 337.639   |  | $ | 2,454,428
|Basic:                                                    |  |                                      |           |   |                                      |   |                                     |  |                                     |           |  |   |          
|Weighted average number of common shares outstanding      |  |                                      | 6,939,613 |   |                                      |   | 6,864,935                           |  |                                     | 6,936,435 |  |   | 6,825,786
|Net income (loss) per share - basic                       |  | $                                    | (0.08     | ) |                                      | $ | 0.06                                |  | $                                   | 0.05      |  | $ | 0.36     
|Diluted:                                                  |  |                                      |           |   |                                      |   |                                     |  |                                     |           |  |   |          
|Dilutive awards                                           |  |                                      | 36,000    |   |                                      |   | 60,000                              |  |                                     | 36,000    |  |   | 60,000   
|Diluted weighted average number common shares outstanding |  |                                      | 6,975,613 |   |                                      |   | 6,924,935                           |  |                                     | 6,973,100 |  |   | 6,885,786
|Net income (loss) per share - diluted                     |  | $                                    | (0.08     | ) |                                      | $ | 0.06                                |  | $                                   | 0.05      |  | $ | 0.36     

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

14. Subsequent Events

On October 10, 2008, the Company paid the dividend for the second quarter of 2008 that was authorized on July 14, 2008 to those stockholders of the Company and unitholders of MHI Hospitality, L.P. of record on September 15,
2008. The dividend was $0.17 per share (unit).



18



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##### Table of Contents

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

Overview

We are a self-advised REIT incorporated in
Maryland in August 2004 to pursue opportunities in the full-service, upper-upscale, upscale and mid-scale segments of the hotel industry. We commenced operations in December 2004 when we completed our initial public offering (IPO) and
thereafter consummated the acquisition of six hotel properties (initial properties).

Our hotel portfolio currently consists of
nine full-service, upper-upscale and mid-scale hotels with 2,113 rooms, which operate under well-known brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. We also own a 25% indirect non-controlling interest in the Crowne Plaza Hollywood
Beach Resort through a joint venture with The Carlyle Group and we have a leasehold interest in a resort condominium facility in Wrightsville Beach, North Carolina.

As of September 30, 2008, we owned the following hotel properties:



|                                |  |                |  |                    |  |                    
|------------------------------- |  | -------------- |  | ------------------ |  | -------------------
|Property                        |  | Numberof Rooms |  | Location           |  | Date of Acquisition
|Operating properties            |  |                |  |                    |  |                    
|Hilton Philadelphia Airport     |  | 331            |  | Philadelphia, PA   |  | December 21, 2004  
|Holiday Inn Laurel West         |  | 207            |  | Laurel, MD         |  | December 21, 2004  
|Holiday Inn Brownstone          |  | 187            |  | Raleigh, NC        |  | December 21, 2004  
|Hilton Wilmington Riverside     |  | 272            |  | Wilmington, NC     |  | December 21, 2004  
|Hilton Savannah DeSoto          |  | 246            |  | Savannah, GA       |  | December 21, 2004  
|Crowne Plaza Jacksonville       |  | 292            |  | Jacksonville, FL   |  | July 22, 2005      
|Sheraton Louisville Riverside   |  | 181            |  | Jeffersonville, IN |  | September 20, 2006 
|Hampton Marina Hotel(1)         |  | 172            |  | Hampton, VA        |  | April 24, 2008     
|Properties under development    |  |                |  |                    |  |                    
|Crowne Plaza Tampa Westshore(2) |  | 225            |  | Tampa, FL          |  | October 29, 2007   
|                                |  |                |  |                    |  |                    
|Total                           |  | 2,113          |  |                    |  |                    
|                                |  |                |  |                    |  |                    



|(1) | On October 7, 2008, the Company completed the hotels conversion to the Crowne Plaza Hampton Marina.
|--- | ----------------------------------------------------------------------------------------------------

|(2) | The property formerly operated as the Tampa Clarion Hotel in Tampa, Florida is undergoing extensive renovations and is expected to re-open as the Crowne Plaza Tampa Westshore in the
first quarter of 2009.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We conduct substantially all our business through our operating partnership, MHI Hospitality, L.P. We
are the sole general partner of our operating partnership, and we own an approximate 65.0% interest in our operating partnership, with the remaining interest being held by the contributors of our initial properties as limited partners.

To qualify as a REIT, we cannot operate hotels. Therefore, our operating partnership leases our hotel properties to MHI Hospitality TRS, LLC, our TRS
Lessee, which then engages a hotel management company to operate the hotels under a management contract. Our TRS Lessee has engaged MHI Hotels Services, LLC 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.

Recent Portfolio Changes

On April 26, 2007, we entered into a program agreement and related
operating agreements with CRP/MHI Holdings, LLC, an affiliate of Carlyle Realty Partners V, L.P. and The Carlyle Group (Carlyle). The agreements provide for the formation of entities to be jointly owned by us and Carlyle, which will
source, underwrite, acquire, develop and operate hotel assets and/or hotel portfolios. Under the agreement, we will offer the joint venture the first right to acquire potential investment opportunities identified by us with total capitalization
requirements in excess of $30.0 million. Carlyle has agreed to commit up to $100.0 million of equity capital to the joint venture over a three-year period. Carlyle will fund up to 90% of the equity of an acquisition, and we will provide between 10%
and 25%.

We will receive an asset management fee of 1.5% of the gross revenues of the hotels owned by the venture. In addition, we will
have a first right of offer with respect to any investment disposed by the joint venture. It is expected that hotels acquired by the joint venture will be managed by MHI Hotels Services.

On August 8, 2007, the joint venture completed the acquisition of the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in
Hollywood, Florida for $74.0 million, with Carlyle retaining a 75% equity position. A portion of the purchase was financed with a two-year $57.6 million non-recourse loan from Société Générale with two one-year extensions
and



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which bore a rate of LIBOR plus 1.94%. On June 13, 2008, the joint venture purchased a $22.0 million junior participation in the mortgage loan and
amended the promissory notes so that the first $35.6 million bears a rate of LIBOR plus 0.98%. The hotel is managed by MHI Hotels Services. We will also receive an asset management fee of 1.5% of gross revenues of the hotel in addition to our share
of the operating profits and proceeds of sale pursuant to the joint venture agreement.

On October 29, 2007, we purchased a 250-room
hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel for the aggregate purchase price of $13.5 million. We are in the process of making extensive renovations to the hotel, including a reconfiguration of guest rooms and suites. Such
renovations are consistent with our repositioning strategy, and upon re-opening, the hotel will be re-branded as a Crowne Plaza with 225 rooms and suites. Renovation costs are estimated at $23.0 million. The cost to acquire and renovate the hotel
has been and will continue to be funded by additional borrowings on the credit facility.

On April 24, 2008, we completed the purchase
of the 172-room Hampton Marina Hotel in Hampton, Virginia for approximately $7.8 million, including transfer costs. To facilitate the purchase, we assumed $5.75 million of existing indebtedness, which bore a rate of 6.50% and was set to mature on
July 1, 2016. The remainder of the purchase price as well as closing costs was funded with borrowings on our credit facility. On June 30, 2008, we refinanced the indebtedness drawing approximately $5.5 million on a three-year $9.0 million
mortgage loan from TowneBank with one 12-month extension. The loan requires monthly payments of interest and bears a rate of LIBOR plus 2.75% during the renovation period and LIBOR plus 2.50% thereafter. The remainder of the proceeds, totaling
approximately $3.5 million, has funded and will continue to fund a product improvement plan (or PIP) for the hotel in connection with its Crowne Plaza licensing. On October 7, 2008, the Company completed the hotels conversion
to the Crowne Plaza Hampton Marina.

On May 1, 2008, we re-opened the Sheraton Louisville Riverside after completing a $16.1 million
renovation.

Key Operating Metrics

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



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



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



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

Results of Operations

The following table
illustrates the actual key operating metrics for the three months and nine months ended September 30, 2008 and 2007 for the properties we owned during each respective reporting period as well as comparable metrics for properties that we owned
and have operated throughout the respective periods.



|                                 |  |                                      |        |   |                                      |   |        |                                     |  |   |                                     |   |  |   |        |  
|-------------------------------- |  | ------------------------------------ | ------ | - | ------------------------------------ | - | ------ | ----------------------------------- |  | - | ----------------------------------- | - |  | - | ------ | -
|                                 |  | Three months endedSeptember 30, 2008 |        |   | Three months endedSeptember 30, 2007 |   |        | Nine months endedSeptember 30, 2008 |  |   | Nine months endedSeptember 30, 2007 |  
|Actual Portfolio Metrics         |  |                                      |        |   |                                      |   |        |                                     |  |   |                                     |   |  |   |        |  
|Occupancy %                      |  |                                      | 59.6   | % |                                      |   | 69.3   | %                                   |  |   | 64.1                                | % |  |   | 71.9   | %
|ADR                              |  | $                                    | 116.43 |   |                                      | $ | 119.24 |                                     |  | $ | 120.13                              |   |  | $ | 119.04 |  
|RevPAR                           |  | $                                    | 69.33  |   |                                      | $ | 82.62  |                                     |  | $ | 77.06                               |   |  | $ | 85.61  |  
|Comparable Portfolio Metrics (1) |  |                                      |        |   |                                      |   |        |                                     |  |   |                                     |   |  |   |        |  
|Occupancy %                      |  |                                      | 65.4   | % |                                      |   | 69.3   | %                                   |  |   | 68.0                                | % |  |   | 71.9   | %
|ADR                              |  | $                                    | 116.10 |   |                                      | $ | 119.24 |                                     |  | $ | 120.25                              |   |  | $ | 119.04 |  
|RevPAR                           |  | $                                    | 75.96  |   |                                      | $ | 82.62  |                                     |  | $ | 81.77                               |   |  | $ | 85.61  |  



|(1) | The hotels included in the comparable portfolio metrics are those that were owned and operated both during 2007 and the nine months ended September 30, 2008. They do not
include results for the Sheraton Louisville Riverside which re-opened May 1, 2008, the property in Hampton, Virginia which was acquired on April 24, 2008, the Crowne Plaza Hollywood Beach Resort in which we have a 25.0% indirect
non-controlling interest or the property in Tampa, Florida which is undergoing renovations and is expected to re-open in the first quarter of 2009 as the Crowne Plaza Tampa Westshore.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Comparison of the Three Months Ended September 30, 2008 to the Three Months Ended September 30, 2007

Revenue. Total revenue for the three months ended September 30, 2008 was approximately $17.2 million, an increase of approximately $0.5
million or 2.7% from total revenue of approximately $16.7 million for the three months ended September 30, 2007. The entire increase was attributable to operations at the Sheraton Louisville Riverside, which re-opened May 1, 2008 and the



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property in Hampton, Virginia, which was acquired April 24, 2008. We expect these properties to contribute significantly to growth in room revenue over
the next year as the Sheraton Louisville Riverside and the re-branded and renovated Crowne Plaza Hampton Marina become established in their markets. While we expect to see overall increases in revenue due to contributions from newly-opened and
newly-renovated properties, we expect revenues from the remainder of our hotel portfolio to be negatively impacted by the weaker economy, higher travel costs and decreased consumer spending.

For the three months ended September 30, 2007, the six properties which we owned throughout 2007 and the nine months ended September 30, 2008
experienced an 8.1 % decrease in room revenue through a combination of a 2.6% decrease in ADR and a 5.6% decrease in occupancy. The most significant contribution to the decrease in room revenue was the renovation in progress at our Savannah,
Georgia hotel, which impacted occupancy during the quarter. We expect improvements in room revenue at this property beginning in the fourth quarter of 2008 and continuing into 2009. We expect that renovation in Savannah will be fully complete in the
first quarter of 2009. We also experienced declines in revenue at our Philadelphia and Jacksonville properties. Those travel markets have been harder hit by the weakening economy than other markets in which we operate.

Food and beverage revenues decreased approximately $0.1 million to approximately $4.0 million for the three months ended September 30, 2008 compared
to food and beverage revenues of approximately $4.1 million for the three months ended September 30, 2007. Contributions to food and beverage revenues from the Sheraton Louisville Riverside and the property in Hampton, Virginia were offset by
decreases at the Hilton Savannah DeSoto, which is undergoing renovation, as well as the Hilton Wilmington Riverside. The Hilton Wilmington Riverside closed its restaurant in 2007 and entered into a lease with a franchisee of Ruths Chris
restaurants. Revenues from the lease are reflected in other operating revenues.

Revenue from other operating departments for the three
months ended September 30, 2008 increased approximately $0.2 million or 16.9% to approximately $1.1 million compared to other operating revenue of approximately $0.9 million for the three months ended September 30, 2007. Lease revenue from
new restaurant tenants at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside as well as the asset management fee we received from the joint venture that owns the Crowne Plaza Hollywood Beach Resort constituted most of the
increase.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other
direct expenses, and management fees, were approximately $13.9 million, an increase of approximately $1.3 million or 10.5% for the three months ended September 30, 2008 compared to approximately $12.6 million for the three months ended
September 30, 2007. If not for the re-opening of the Sheraton Louisville Riverside and the acquisition of the property in Hampton, Virginia, hotel operating expenses would have decreased approximately $0.5 million. While we expect the overall
level of hotel operating expenses to increase as the newly-opened Sheraton Louisville Riverside and the re-branded Crowne Plaza Hampton Marina become established in their markets, we expect that such increases will be tempered by cost-cutting
initiatives at our other properties in response to weaker consumer demand due to higher travel costs and the weaker economy.

Rooms expense
for the three months ended September 30, 2008 increased to approximately $3.5 million, an increase of approximately $0.4 million or 14.2% for the three months ended September 30, 2008 compared to approximately $3.0 million for the three
months ended September 30, 2007. Rooms expense from the Sheraton Louisville Riverside and the property in Hampton, Virginia accounted for the entire increase.

Food and beverage expenses for the three months ended September 30, 2008 increased approximately $0.1 million to approximately $3.2 million compared to food and beverage expenses of approximately $3.1 million for
the three months ended September 30, 2007. Lower food and beverage margins were severely impacted at the Hilton Savannah DeSoto by the decline in banqueting sales during renovation of the public spaces, as well as the write-off of food
inventories due to spoilage following two citywide electric outages in Savannah, Georgia this summer.

Indirect expenses at our properties
for the three months ended September 30, 2008 increased approximately $0.8 million or 12.0% to approximately $7.0 million compared to indirect expenses of approximately $6.2 million for the three months ended September 30, 2007. Indirect
expenses related to the Sheraton Louisville Riverside and the property in Hampton, Virginia account for the increase in indirect expenses and were tempered by cost-cutting initiatives at our remaining properties.

Depreciation and Amortization. Depreciation and amortization expense for the three months ended September 30, 2008 increased approximately
$0.6 million or 46.4% to approximately $1.8 million compared to depreciation and amortization expense of approximately $1.2 million for the three months ended September 30, 2007. The increase in depreciation and amortization was attributable to
the renovations placed in service at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside, as well as the acquisition of the property in Hampton, Virginia.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended September 30, 2008 remained
constant at approximately $0.6 million compared to corporate general and administrative expense for the three months ended September 30, 2007.



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Interest Expense. Interest expense for the three months ended September 30, 2008 increased
approximately $0.9 million or 84.6% to approximately $1.9 million compared to interest expense for the three months ended September 30, 2007, primarily due to higher levels of borrowings on the credit facility and higher levels of mortgage
debt. The increased interest expense relates to borrowing used to fund the purchase of the property in Hampton, Virginia as well as renovations at the Hilton Wilmington Riverside, the Sheraton Louisville Riverside, the Hilton Savannah DeSoto and the
property in Hampton, Virginia.

Impairment of Note Receivable. Impairment of note receivable represents a $0.1 million valuation
allowance against the $0.4 million promissory note we received upon the sale of the Holiday Inn Downtown Williamsburg in August 2006. In August 2008, the property was sold at auction for less than the total mortgage indebtedness on the property. We
are pursuing the collection of the note, which was guaranteed by individuals affiliated with the debtor. A charge for impairment is being taken in anticipation that a negotiated settlement for less than the full value of the note is more likely to
occur than collection of the full face value of the note.

Equity in Joint Venture. Equity in joint venture for the three months
ended September 30, 2008 represents our 25.0% share of the net loss from operations of the Crowne Plaza Hollywood Beach Resort. For the three months ended September 30, 2008, the hotel reported occupancy of 54.9%, ADR of $113.71 and RevPAR
of $62.40.

Income Taxes. The income tax benefit for the three months ended September 30, 2008 increased approximately $0.3
million or 105.3% to approximately $0.6 million. The income tax benefit is primarily derived from the operations of our TRS lessee. The net operating loss of our TRS lessee for the three months ended September 30, 2008 was greater than the net
operating loss for the three months ended September 30, 2007.

Net Income (Loss). The net operating results for the Company for
the three months ended September 30, 2008 decreased to a loss of approximately $0.5 million from net income of approximately $0.4 million for the three months ended September 30, 2007 as a result of the operating results discussed above.

Comparison of the Nine Months Ended September 30, 2008 to the Nine Months Ended September 30, 2007

Revenue. Total revenue for the nine months ended September 30, 2008 was approximately $53.2 million, an increase of approximately $0.1 million
or 0.3% from the nine months ended September 30, 2007. If not for revenue from the Sheraton Louisville Riverside, which re-opened May 1, 2008, and the property in Hampton, Virginia, which was acquired April 24, 2008, total revenue
would have decreased approximately $3.1 million.

The six properties which we owned throughout 2007 and the nine months ended
September 30, 2008 experienced a 4.2% decrease in room revenue despite a 1.0% increase in ADR, which was offset by a 5.4% decrease in occupancy. Most of the decrease in room revenue is attributable to renovations in progress at our Wilmington,
North Carolina and Savannah, Georgia properties, which impacted occupancy during the quarter. We have seen improvements in room revenue following the completion of renovations at the Hilton Wilmington Riverside and expect similar improvements in
room revenue at the Hilton Savannah DeSoto beginning in the fourth quarter of 2008 continuing into 2009. We expect that the renovation of the Hilton Savannah DeSoto will be fully completed in the first quarter of 2009. While we expect to see overall
increases in revenue due to contributions from newly-opened and newly-renovated properties, we expect revenues from the remainder of our hotel portfolio to be negatively impacted by the weaker economy, higher travel costs and decreased consumer
spending.

The largest decrease in revenue was from food and beverage revenues, which, for the nine months ended September 30, 2008
declined to approximately $13.3 million, a decrease of approximately $1.0 million or 6.9% compared to food and beverage revenues of approximately $14.3 million for the nine months ended September 30, 2007. While earlier in the year, room sales
from group business has remained strong at properties not undergoing renovation, there had been less demand for banqueting services resulting in a decrease in food and beverage revenue. As the economy weakened into the third quarter of 2008, demand
for banqueting services continued to decline. Additionally, we realized lower food and beverage revenue at the Hilton Wilmington Riverside, which closed one of its restaurants in 2007 in order to renovate it for use by a franchisee of Ruths
Chris restaurants beginning in June 2008. Revenues from the new lease are reflected in other operating revenues.

Revenue from other
operating departments for the nine months ended September 30, 2008 increased approximately $0.4 million or 13.1% to approximately $3.2 million compared to other operating revenue of approximately $2.8 million for the nine months ended
September 30, 2007. Lease revenue from new restaurant tenants at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside as well as the asset management fee we received from the joint venture that owns the Crowne Plaza Hollywood
Beach Resort constituted a significant portion of the increase.

Hotel Operating Expenses. Hotel operating expenses, which consist
of room expenses, food and beverage expenses, other direct expenses, and management fees, were approximately $41.7 million, an increase of approximately $2.4 million or 6.1% for the nine months ended September 30, 2008 compared to approximately
$39.3 million for the nine months ended September 30, 2007. If not for the re-opening of the Sheraton Louisville Riverside and the acquisition of the property in Hampton, Virginia, hotel operating expenses would have decreased approximately
$1.2 million.



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Rooms expense for the nine months ended September 30, 2008 increased to approximately $10.2 million,
an increase of approximately $0.9 million or 9.2% for the nine months ended September 30, 2008 compared to approximately $9.3 million for the nine months ended September 30, 2007. Rooms expense from the Sheraton Louisville Riverside and
the property in Hampton, Virginia, as well as additional charges for three months of outside laundry services at our Philadelphia property necessitated by the breakdown of laundry equipment in mid-January 2008, contributed to the increase in rooms
expense.

Food and beverage expenses for the nine months ended September 30, 2008 decreased approximately $0.1 million or 1.5% to
approximately $10.0 million compared to food and beverage expenses of approximately $10.1 million for the nine months ended September 30, 2007. A significant decrease in sales of food and beverage through lower orders of banqueting services at
our hotels was partially offset by higher food costs in the first quarter as well as the write-off of food inventories due to spoilage following two citywide electric outages at the Hilton Savannah DeSoto this summer.

Indirect expenses at our properties for the nine months ended September 30, 2008 increased approximately $1.7 million or 8.8% to approximately $20.9
million compared to indirect expenses of approximately $19.2 million for the nine months ended September 30, 2007. Indirect expenses related to the Sheraton Louisville Riverside and the property in Hampton, Virginia, including approximately
$0.3 million of start-up costs at the Sheraton Louisville Riverside, account for the increase in indirect expenses.

Depreciation and
Amortization. Depreciation and amortization expense for the nine months ended September 30, 2008 increased approximately $1.1 million or 29.9% to approximately $4.8 million compared to depreciation and amortization expense of approximately
$3.7 million for the nine months ended September 30, 2007. The increase in depreciation and amortization was attributable to the renovations placed in service at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside as well as
the acquisition of the property in Hampton, Virginia.

Corporate General and Administrative. Corporate general and administrative
expenses for the nine months ended September 30, 2008 decreased approximately $0.1 million or 1.9% to approximately $2.3 million compared to corporate general and administrative expense of approximately $2.4 million for the nine months ended
September 30, 2007. One-time costs incurred in the prior period associated with structuring the program and operating agreements that allow us to jointly acquire, develop and operate hotels assets and hotel portfolios with Carlyle contributed
to the decrease.

Interest Expense. Interest expense for the nine months ended September 30, 2008 increased approximately $1.7
million or 54.3% to approximately $4.8 million compared to interest expense of approximately $3.1 million for the nine months ended September 30, 2007, primarily due to increased borrowings on the credit facility used to fund the renovations at
the Hilton Wilmington Riverside. Additionally, we are realizing interest expense on the borrowings associated with the Sheraton Louisville Riverside subsequent to its re-opening and completion of its renovations as well as borrowings associated with
the purchase of the property in Hampton, Virginia. Lastly, we incurred an interest penalty of approximately $0.1 million associated with pre-payment of the indebtedness on that hotel when it was refinanced with a new $9.0 million mortgage from
TowneBank.

Impairment of Note Receivable. Impairment of note receivable represents a $0.3 million valuation allowance against the
$0.4 million promissory note we received upon sale of the Holiday Inn Downtown Williamsburg in August 2006. In August 2008, the property was sold at auction for less than the total mortgage indebtedness on the property. We are pursuing the
collection of the note, which was guaranteed by individuals affiliated with the debtor. A charge for impairment is being taken in anticipation that a negotiated settlement for less than the full value of the note is more likely to occur than
collection of the full face value of the note.

Equity in Joint Venture. Equity in joint venture for the nine months ended
September 30, 2008 represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort. During the nine months ended September 30, 2008, the joint venture was able to restructure the mortgage on the property by
purchasing a $22.0 million junior participation at a price of $19.0 million resulting in a $3.0 million gain on extinguishment of debt to the joint venture. For the nine months ended September 30, 2008, the hotel reported occupancy of 59.0%,
ADR of $154.22 and RevPAR of $90.95.

Income Taxes. The effect of income taxes swung from an income tax provision of approximately
$0.1 million for the nine months ended September 30, 2007 to an income tax benefit of approximately $1.0 million for the nine months ended September 30, 2008. The income tax benefit or provision is primarily derived from the operations of
our TRS lessee. Our TRS lessee experienced a taxable loss for the nine months ended September 30, 2008 in contrast to generating taxable income for the nine months ended September 30, 2007.

Net Income. The net income for the nine months ended September 30, 2008 decreased approximately $2.1 million or 86.2% to approximately $0.3
million from net income of approximately $2.4 million for the nine months ended September 30, 2007 as a result of the operating results discussed above.

Funds From Operations

Funds from Operations (FFO) is used by industry analysts and investors as a
supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts, NAREIT. FFO, as defined by
NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously



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depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any
minority interest from unconsolidated partnerships and joint ventures. Historical cost accounting for real estate assets in accordance with GAAP implicitly assumes that the value of real estate assets diminishes predictably over time. Since real
estate values instead have historically risen or fallen with market conditions, many investors and analysts have considered the presentation of operating results for real estate companies that use historical cost accounting to be insufficient by
itself. Thus, NAREIT created FFO as a supplemental measure of REIT operating performance that excludes historical cost depreciation, among other items, from GAAP net income.

Management believes that the use of FFO, combined with the required GAAP presentations, has improved the understanding of the operating results of REITs
among the investing public and made comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure of adjusted net income for reviewing comparative operating and financial performance because we believe FFO is
most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset
depreciation and amortization, FFO assists in comparing the operating performance of a companys real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not
calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.

The following table reconciles net income to FFO for the three months and nine months ended September 30, 2008 and 2007 (unaudited):



|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           
|------------------------------------------------ |  | ------------------------------------ | ---------- | - | ------------------------------------ | - | ---------- | ----------------------------------- |  | ----------------------------------- | ---------- |  | - | ----------
|                                                 |  | Three Months EndedSeptember 30, 2008 |            |   | Three Months EndedSeptember 30, 2007 |   |            | Nine Months EndedSeptember 30, 2008 |  | Nine Months EndedSeptember 30, 2007
|Net income (loss)                                |  | $                                    | (523,773   | ) |                                      | $ | 409,119    |                                     |  | $                                   | 337,639    |  | $ | 2,454,428 
|Add minority interest                            |  |                                      | (282,336   | ) |                                      |   | 219,056    |                                     |  |                                     | 181,933    |  |   | 1,369,267 
|Add depreciation and amortization                |  |                                      | 1,797,075  |   |                                      |   | 1,227,443  |                                     |  |                                     | 4,777,680  |  |   | 3,677,762 
|Add equity in depreciation of joint venture      |  |                                      | 136,432    |   |                                      |   | 13,893     |                                     |  |                                     | 409,244    |  |   | 13,893    
|Add/(Subtract) loss/(gain) on disposal of assets |  |                                      | (2,010     | ) |                                      |   | (4,863     | )                                   |  |                                     | 114,962    |  |   | 9,404     
|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           
|FFO                                              |  | $                                    | 1,125,388  |   |                                      | $ | 1,864,648  |                                     |  | $                                   | 5,821,458  |  | $ | 7,524,754 
|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           
|Weighted average shares outstanding              |  |                                      | 6,939,613  |   |                                      |   | 6,864,935  |                                     |  |                                     | 6,936,435  |  |   | 6,825,786 
|Weighted average units outstanding               |  |                                      | 3,737,607  |   |                                      |   | 3,769,672  |                                     |  |                                     | 3,737,607  |  |   | 3,807,936 
|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           
|Weighted average shares and units                |  |                                      | 10,677,220 |   |                                      |   | 10,634,607 |                                     |  |                                     | 10,674,042 |  |   | 10,633,722
|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           
|FFO per share and unit                           |  | $                                    | 0.11       |   |                                      | $ | 0.18       |                                     |  | $                                   | 0.55       |  | $ | 0.71      
|                                                 |  |                                      |            |   |                                      |   |            |                                     |  |                                     |            |  |   |           

Sources and Uses of Cash

Operating Activities.Our principal source of cash to meet our operating requirements, including distributions to unitholders and stockholders as well as repayments of indebtedness, is the operations of our
hotels. Cash flow provided by operating activities for the nine months ended September 30, 2008 was approximately $2.5 million. We currently expect that the net cash provided by operations will be adequate to fund our continuing operations,
debt service and the payment of dividends in accordance with federal income tax laws which require us to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gains. We paid dividends of
$0.17 per share (unit) on April 11, 2008, July 11, 2008 and October 11, 2008, which we funded out of working capital.

Investing Activities. Approximately $29.8 million was spent during the nine months ended September 30, 2008 on renovations and capital improvements. Approximately $12.4 million was spent on renovations at the Wilmington Hilton
Riverside and the Sheraton Louisville Riverside in order to bring those projects to completion. Approximately $15.8 million was spent on renovations at the Savannah Hilton DeSoto, the property in Tampa, Florida as well as the property in Hampton,
Virginia, all of which progressed during the period.

During the nine months ended September 30, 2008 we spent approximately $2.1
million to acquire the property in Hampton, Virginia and assumed the existing indebtedness on the hotel. We also contributed approximately $4.8 million to our joint venture with Carlyle to acquire a 25.0% indirect interest in a $22.0 million junior
participation in the mortgage on the Crowne Plaza Hollywood Beach Resort.

Financing Activities. During the nine months ended
September 30, 2008, we borrowed $32.8 million on our credit facility, $9.0 million on the mortgage on the Savannah Hilton DeSoto and approximately $1.4 million on the mortgage on the property in Hampton, Virginia in order to fund the investing
activities discussed above as well as provide working capital. On June 30, 2008, we refinanced the existing indebtedness on the property in Hampton, Virginia.



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Capital Expenditures

Recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment, as well as debt service, are our 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. With respect to three of our hotels, the reserve accounts are
escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures. We deposit an amount equal to 4% of gross revenue for both the Hilton Savannah DeSoto and Hilton Wilmington Riverside and 4% of room revenues for
the Crowne Plaza Jacksonville. Our intent for the capital expenditures at all hotels, exclusive of improvements or renovations required by franchisors, is to maintain overall capital expenditures at 4% of gross revenue.

In July 2007, the franchise license for the Hilton Savannah DeSoto Hotel was renewed and extended to July 2018. To comply with the re-licensing
agreement, we must complete a PIP, which we expect to be completed during the first quarter of 2009 and total approximately $11.0 million. Approximately $7.3 million had been expended as of September 30, 2008. The renovations will be funded by
additional borrowings on our credit facility.

On October 29, 2007, we purchased the property formerly known as the Tampa Clarion
Hotel in Tampa, Florida with the intention of renovating and re-branding the hotel. On October 31, 2007, we obtained a 10-year franchise agreement with InterContinental Hotels Group to brand the property as a Crowne Plaza hotel. Renovation
costs are estimated at approximately $23.0 million, of which approximately $8.0 million had been expended as of September 30, 2008. The renovations will be funded by additional borrowings on our credit facility.

On April 24, 2008, we purchased the Hampton Marina Hotel in Hampton, Virginia for approximately $7.8 million, including transfer costs. On
February 27, 2008, we obtained a 10-year franchise agreement with InterContinental Hotels Group to brand the property as the Crowne Plaza Hampton Marina. In conjunction with the license agreement, we are required to complete a PIP. Renovation
costs are estimated at approximately $4.5 million, of which approximately $3.4 million had been expended as of September 30, 2008. Renovations will be funded by additional draws of approximately $2.0 million on the mortgage that was refinanced
in June 2008 and by additional borrowings on our credit facility.

Liquidity and Capital Resources

As of September 30, 2008, we had cash and cash equivalents of approximately $9.0 million, of which approximately $2.1 million was in restricted
reserve accounts and approximately $0.4 million was in real estate tax escrows. As of September 30, 2008, our revolving credit facility, which was amended on April 15, 2008 so that we may borrow up to $80.0 million, had an outstanding
balance of approximately $67.2 million. We expect that the cash flow from our hotels will be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment as well as
debt service.

We estimate that to complete the capital projects to which we are committed, we will require capital of approximately $20.8
million. More than half of that amount will be required before the end of the year with no more than $8.0 million required in the first quarter of 2009. We expect that approximately $2.0 million will be obtained through additional draws on the
mortgage on the Crowne Plaza Hampton Marina. In addition, we have approximately $1.8 million in the restricted reserves accounts for the Hilton Wilmington Riverside and the Hilton Savannah DeSoto, which are available to us. Lastly, we have an
agreement with Carlyle, our joint venture partner, that should the $22.0 million junior participation in the mortgage on the Crowne Plaza Hollywood Beach Resort not be re-sold before the end of fiscal year 2008, we may borrow an amount equal to our
pro-rata share of the capital contribution required to fund the purchase of the $22.0 million junior participation, or approximately $4.8 million, from them at LIBOR plus 3.50%. We believe that the additional borrowing capacity on our credit
facility as well as the other capital resources described above provide us sufficient capital to accommodate our needs for committed capital projects as well as working capital.

Our ability to fund future acquisitions relies on our ability to raise additional capital. Sources of additional capital may include a combination of
some or any of the following:



| |  |  | The issuance by the Company, the operating partnership of the Company, and/or their subsidiary entities of secured and unsecured debt securities;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  |  | the issuance of additional units in the operating partnership;
| | - |  | --------------------------------------------------------------



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



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

Without
additional capital, we would have to forego future acquisitions.

The current crisis in the financial markets has resulted in a very
difficult borrowing environment. Although we have no significant debt maturing in 2009, we have significant debt coming due in 2010 and 2011. While we are unable to predict what conditions will exist in the borrowing environment at that time,
we believe that the value of the collateral assets will be sufficient to support refinancing of the current loan amounts if credit market conditions return to historic levels. In the absence of available credit on acceptable terms, we may be
required to dispose of assets, raise equity capital or pursue other financing alternatives.

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



| |  |  | The issuance by the Company, the operating partnership of the Company, and/or their subsidiary entities of secured and unsecured debt securities;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



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



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



| |  |  | the issuance of additional units in the operating partnership;
| | - |  | --------------------------------------------------------------



| |  |  | 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
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.

Dividend Policy

Generally, we intend to continue to distribute to our stockholders each year on a
regular quarterly basis sufficient amounts of our REIT taxable income so as to avoid paying corporate income tax and excise tax on our earnings (other than the earnings of our TRS and TRS lessees, which are all subject to tax at regular corporate
rates) and to qualify for the tax benefits afforded to REITs under the Internal Revenue Code of 1986, as amended (the Code). In order to qualify as a REIT under the Code, we generally must make distributions to our stockholders each year
in an amount equal to at least:



| |  |  | 90% of our REIT taxable income determined without regard to the dividends paid deduction, plus
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | 90% of the excess of our net income from foreclosure property over the tax imposed on such income by the Code, minus
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | any excess non-cash income.
| | - |  | ---------------------------

We pay
quarterly cash dividends to common stockholders at the discretion of our Board of Directors. The following table sets forth the dividends paid to common stockholders since January 1, 2008:



|                 |  |                    |  |                    |     
|---------------- |  | ------------------ |  | ------------------ | ----
|Payment Date     |  | Record Date        |  | Dividend Per Share
|January 11, 2008 |  | December 14, 2007  |  | $                  | 0.17
|April 11, 2008   |  | March 14, 2008     |  | $                  | 0.17
|July 11, 2008    |  | June 16, 2008      |  | $                  | 0.17
|October 10, 2008 |  | September 15, 2008 |  | $                  | 0.17



26



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In light of ongoing challenging economic conditions, we are evaluating the merits of reducing its future
dividend payments in order to align the dividend payout with market conditions and to conserve cash. We expect to complete this evaluation and review with the Board of Directors later this year and do not expect to make a decision on the level of
future dividends until that review is completed.

Off-Balance Sheet Arrangements

Through a joint venture with Carlyle, we own a 25.0% indirect non-controlling interest in an entity (the JV Owner) that acquired the 311-room
Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We have the right to receive a pro rata share of operating surpluses as well as an obligation to fund our pro rata share of operating shortfalls. We also have the opportunity to earn an
incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort is
leased to another entity (the Joint Venture Lessee) in which we also own a 25.0% indirect non-controlling equity interest. Adjacent to the Crowne Plaza Hollywood Beach Resort is a three-acre hotel development site which is leased by a
joint venture entity. The lessee, in which we have a 25.0% indirect ownership interest, has an option to purchase the site, which is improved with a parking garage currently being used by the Hollywood hotel. The purchase option expires in August
2011 and allows the site to be purchased for fair market value as determined by independent appraisal, but not less than $5.0 million or more than $10.0 million. Carlyle owns a 75.0% controlling interest in this entity as well as the JV Owner and
the Joint Venture Lessee. Carlyle may elect to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We account for our non-controlling 25.0% interest in both the JV Owner and the Joint Venture Lessee under the equity method of
accounting.

The acquisition of the Crowne Plaza was funded in part by a mortgage loan in the amount of $57.6 million. The mortgage, which
has a two-year term maturing on August 1, 2009, was restructured on June 13, 2008 so that the first $35.6 million bears interest at a rate of LIBOR plus additional interest of 0.98%. The remaining $22.0 million bears a rate of LIBOR plus
3.50%. Upon the restructure, another entity in which we own a 25.0% indirect non-controlling interest purchased the $22.0 million junior participation for $19.0 million. The loan can be extended for two one-year periods. The JV Owner executed an
interest rate cap agreement capping LIBOR at 6.25%, effectively limiting the rate on the first $35.6 million of the mortgage to 7.23% and limiting the effective rate on the entire mortgage to approximately 8.19%. Monthly interest-only payments are
due throughout the term. The Crowne Plaza Hollywood Beach Resort secures the mortgage. We have provided limited guarantees to the lender with respect to this mortgage.

Inflation

We generate revenues primarily from lease payments from our TRS Lessee and net income from
the operations of our TRS Lessee. Therefore, we rely primarily on the performance of the individual properties and the ability of our management company to increase revenues and to keep pace with inflation. Operators of hotels, in general, possess
the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of our management company to raise room rates.

Our expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to
inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at
rates higher than inflation.

Seasonality

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

Geographic
Concentration

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

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. 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



27



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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 at time of acquisition.

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

There were no charges for impairment recorded for the nine months ended September 30, 2008 or 2007.

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 revenue, including room, food, beverage and other hotel revenue, is 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.

Income Taxes. We record a
valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS Lessee, we have not recorded a valuation allowance to reduce our net deferred
tax asset as of September 30, 2008. Should our estimate of future taxable income be less than expected, we would record an adjustment to the net deferred tax asset in the period such determination was made.

Recent Accounting Pronouncements

On
September 15, 2006, the FASB issued SFAS No. 157, Fair Value Measurements(SFAS 157). SFAS 157 establishes a framework for measuring fair value and expands disclosures about fair value measurements. The changes to
current practice resulting from the application of SFAS 157 relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements. SFAS 157 was originally effective for fiscal
years beginning after November 15, 2007 and interim periods within those fiscal years but was amended on February 6, 2008 to defer the effective date for one year for certain non-financial assets and liabilities. We adopted SFAS 157 on
January 1, 2008, which had no material impact on our financial statements.

In February 2007, the FASB issued SFAS No. 159,
The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159). SFAS 159 is effective for fiscal years beginning after November 15, 2007. SFAS 159 allows entities to choose, at specified election dates, to
measure eligible financial assets and liabilities at fair value that are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that items fair value in subsequent
reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities.
We adopted SFAS 159 on January 1, 2008, which had no material impact on our consolidated financial statements.

In December 2007,
the FASB issued SFAS No. 141R Business Combinations(SFAS 141(R)). SFAS 141(R) establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable
assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination, recognizing assets acquired and
liabilities assumed arising from contingencies, and determining what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS 141(R) is effective for
acquisitions consummated in fiscal years beginning after December 15, 2008. We expect SFAS 141(R) will have an impact on our consolidated financial statements when effective, but the nature and magnitude of the specific effects will depend upon
the nature, terms and size of the acquisitions we consummate after the effective date.



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In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated
Financial Statements (SFAS 160). SFAS 160 changes the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. This new consolidation method
significantly changes the accounting for transactions with minority interest holders. SFAS 160 is effective for fiscal years beginning after December 15, 2008 with early application prohibited. We are currently evaluating what impact SFAS 160
will have on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities(SFAS 161). SFAS 161 requires expanded disclosures regarding the location and amounts of derivative instruments in an entitys financial statements, how derivative instruments and related
hedged items are accounted for under SFAS 133, Accounting for Derivative Instruments and Hedging Activities, and how derivative instruments and related hedged items affect an entitys financial position, operating results and cash
flows. SFAS 161 is effective for periods beginning on or after November 15, 2008. We are currently evaluating what impact SFAS 161 will have on our consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position No. 142-3, Determination of the Useful Life of Intangible Assets(FSP 142-3)
to improve the consistency between the useful life of a recognized intangible asset (under SFAS 142) and the period of expected cash flows used to measure the fair value of the intangible asset (under SFAS 141(R)). FSP 142-3 amends the factors to be
considered when developing renewal or extension assumptions that are used to estimate an intangible assets life under SFAS 142. The guidance in the new staff position is to be applied progressively to intangible assets acquired after
December 31, 2008. In addition, FSP No. 142-3 increases the disclosure requirements related to renewal or extension assumptions. We are currently evaluating the impact of FSP 142-3 on our financial statements.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles(SFAS 162). SFAS 162
identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting
principles (GAAP) in the United States (the GAAP hierarchy). SFAS 162 is effective 60 days following the SECs approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. We are currently evaluating the impact of the SFAS 162 on our financial statements.

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:



| |  |  | National and local economic and business conditions, including the current economic downturn, that will affect occupancy rates at the Companys hotels and the
demand for hotel products and services;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks associated with the hotel industry, including competition, increases in wages, energy costs and other operating costs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | the availability and terms of financing and capital and the general volatility of the securities markets, specifically, the current credit crisis;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks associated with the level of the Companys indebtedness and its ability to meet covenants in its debt agreements;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| |  |  | management and performance of the Companys hotels;
| | - |  | ---------------------------------------------------



| |  |  | risks associated with redevelopment and repositioning projects, including delays and cost overruns;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | supply and demand for hotel rooms in the Companys current and proposed market areas;
| | - |  | -------------------------------------------------------------------------------------



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



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

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 Annual Report on Form 10-K and subsequent reports filed with the Securities and Exchange Commission.

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 could 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. Our credit facility required us to hedge at least one-half of the maximum borrowing amount with an
interest-rate swap, which we purchased on August 8, 2006 on a notional amount of $30.0 million. As of September 30, 2008, derivatives with a fair value of approximately $(1.1) million were included in accounts payable and other accrued
liabilities. From time to time we may enter into other interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue
these derivative contracts for trading or speculative purposes.

As of September 30, 2008, we had $64.0 million of fixed-rate debt and
approximately $74.2 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 6.66%. 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. Our variable-rate debt is exposed to changes in interest rates, specifically the change in 30-day LIBOR, but would be limited to the effect on our mortgage on the Crowne Plaza Hampton Marina and the gap between the
balance on the credit facility and the $30.0 million notional amount of the interest-rate swap purchased on August 8, 2006. Assuming that the amount outstanding on our mortgage on the Crowne Plaza Hampton Marina and the amount outstanding under
our credit facility remain at approximately $74.2 million, the balance at September 30, 2008, the impact on our annual interest incurred and cash flows of a one percent change in 30-day LIBOR would be approximately $442,000.

As of December 31, 2007, we had $55.0 million of fixed-rate debt and approximately $34.4 million of variable-rate debt. The weighted average
interest rate on the fixed-rate debt was 6.76%. At that date, our variable-rate debt was exposed to changes in interest rates, specifically the change in 30-day LIBOR, but was limited to the effect on the gap between the balance on the credit
facility and the $30.0 million notional amount of the interest-rate swap. Had the amount outstanding under the credit facility remained at approximately $34.4 million, the balance at December 31, 2007, the impact on our annual interest incurred
and cash flows of a one percent change in 30-day LIBOR would have been approximately $44,000.



|Item 4T. | 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.

As of September 30, 2008, 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.



30



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PART II



|Item 1. | Legal Proceedings
|------- | -----------------

We are not
involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business. We believe that these routine legal proceedings, in the aggregate, are not material to our financial condition and results of
operations.



|Item 1A. | Risk Factors
|-------- | ------------

Our Risk Factors
are discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. We have updated our risk factors as stated below to address the effect of the current credit crisis and current market conditions on our business.

We may not be able to obtain corporate financing in the future, and the terms of any future financings may limit our ability to manage our business.
Difficulties in obtaining financing on favorable terms would have a negative effect on our ability to execute our business strategy.

In addition to capital available under our revolving credit facility, we anticipate that we may be required to seek additional capital in the future, including financing necessary to refinance or replace existing long-term debt or to fund
capital expenditures. There can be no assurance that we will be able to obtain future financings, if needed, on acceptable terms, if at all. Currently, we have no significant debt maturing prior to July 2010.

If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may
not be able to execute our business strategies. Moreover, the terms of any additional financing may restrict our financial flexibility, including the debt we may incur in the future, or may restrict our ability to manage our business as we had
intended.

Our liquidity, including access to capital markets and financing, could be constrained by limitations in the overall credit markets, our
credit ratings and our ability to comply with financial covenants in our debt instruments.

Our ability to borrow under our
existing financial arrangements depends on our compliance with covenants in the related agreements, and on our performance against covenants in our revolving credit facility that require compliance with certain financial ratios as of the end of each
fiscal year. To the extent that we are unable to maintain compliance with these requirements or to perform against the financial ratio covenants, due to one or more of the various risk factors discussed herein or otherwise, our ability to borrow,
and our liquidity, would be adversely impacted.



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

Not applicable.



|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.



|Item 6. | Exhibits
|------- | --------

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



|              |  |                                                                                                                                                                                        
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                 
|3.1           |  | Articles of Amendment and Restatement of MHI Hospitality Corporation.(1)                                                                                                               
|              | 
|3.2           |  | Amended and Restated Bylaws of MHI Hospitality Corporation.(2)                                                                                                                         
|              | 
|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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|(1) | Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrants Pre-Effective Amendment No. 1 to its Registration Statement on
Form S-11 filed with the Securities and Exchange Commission on October 20, 2004. (333-118873)
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrants Pre-Effective Amendment No. 5 to its Registration Statement on
Form S-11 filed with the Securities and Exchange Commission on December 13, 2004. (333-118873)
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURE

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



|                        |  |  |  |                             |  |                                                  
|----------------------- |  |  |  | --------------------------- |  | -------------------------------------------------
|                        |  |  |  | MHI HOSPITALITY CORPORATION
|                        |  |  | 
|Date: November 13, 2008 |  |  |  | By:                         |  | /s/ Andrew M. Sims                               
|                        |  |  |  |                             |  | Andrew M. Sims                                   
|                        |  |  |  |                             |  | Chief Executive Officer and Chairman of the Board
|                        |  |  | 
|                        |  |  |  | By:                         |  | /s/ William J. Zaiser                            
|                        |  |  |  |                             |  | William J. Zaiser                                
|                        |  |  |  |                             |  | Chief Financial Officer                          



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EXHIBIT INDEX



|              |  |                                                                                                                                                                                        
|------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                 
|3.1           |  | Articles of Amendment and Restatement of MHI Hospitality Corporation.(1)                                                                                                               
|              | 
|3.2           |  | Amended and Restated Bylaws of MHI Hospitality Corporation.(2)                                                                                                                         
|              | 
|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.                                     



|(1) | Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrants Pre-Effective Amendment No. 1 to its Registration Statement on
Form S-11 filed with the Securities and Exchange Commission on October 20, 2004. (333-118873)
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrants Pre-Effective Amendment No. 5 to its Registration Statement on
Form S-11 filed with the Securities and Exchange Commission on December 13, 2004. (333-118873)
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



34