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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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

For the quarterly period ended September 30, 2006

OR



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

For the transition period from  to
.

Commission file number 001-32379



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MHI
HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|MARYLAND                                                       |  | 20-1531029                          
|(State or Other Jurisdiction of 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 an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Large Accelerated Filer ̈Accelerated Filer ̈Non-accelerated Filer  x

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

As of November 6, 2006, there were 6,712,000 shares of the registrants common stock issued and outstanding.



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##### Table of Contents

MHI HOSPITALITY CORPORATION

INDEX



|         |  |                                                                                       |  |     
|-------- |  | ------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                       |  | Page
|PART I   |  |                                                                                      
|         |  |                                                                                      
|Item 1.  |  | Financial Statements                                                                  |  | 3   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 16  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 24  
|Item 4.  |  | Controls and Procedures                                                               |  | 25  
|         | 
|PART II  |  |                                                                                      
|Item 1.  |  | Legal Proceedings                                                                     |  | 26  
|Item 1A. |  | Risk Factors                                                                          |  | 26  
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 26  
|Item 3.  |  | Defaults Upon Senior Securities                                                       |  | 26  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                   |  | 26  
|Item 5.  |  | Other Information                                                                     |  | 26  
|Item 6.  |  | Exhibits                                                                              |  | 27  



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##### Table of Contents

PART I

Item 1.Financial Statements

MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ----------- | - | ----------------- | - | ----------- | -
|                                                                                                                                                                                    |  | September 30, 2006 |             |   | December 31, 2005 |  
|                                                                                                                                                                                    |  | (unaudited)        |             |   |                   |  
|ASSETS                                                                                                                                                                              |  |                    |             |   |                   |   |             |  
|Investment in hotel properties, net                                                                                                                                                 |  | $                  | 109,995,442 |   |                   | $ | 101,583,250 |  
|Cash and cash equivalents                                                                                                                                                           |  |                    | 2,630,465   |   |                   |   | 501,810     |  
|Restricted cash                                                                                                                                                                     |  |                    | 3,165,130   |   |                   |   | 4,330,981   |  
|Accounts receivable                                                                                                                                                                 |  |                    | 2,601,385   |   |                   |   | 2,095,193   |  
|Accounts receivable-affiliate                                                                                                                                                       |  |                    | 10,897      |   |                   |   | 242,362     |  
|Prepaid expenses, inventory and other assets                                                                                                                                        |  |                    | 2,553,514   |   |                   |   | 1,917,038   |  
|Assets held for sale                                                                                                                                                                |  |                    |            |   |                   |   | 4,451,912   |  
|Notes receivable                                                                                                                                                                    |  |                    | 4,430,000   |   |                   |   |            |  
|Shell Island lease purchase, net                                                                                                                                                    |  |                    | 2,779,411   |   |                   |   | 3,088,235   |  
|Deferred financing costs, net                                                                                                                                                       |  |                    | 857,452     |   |                   |   | 175,142     |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL ASSETS                                                                                                                                                                        |  | $                  | 129,023,696 |   |                   | $ | 118,385,923 |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|LIABILITIES                                                                                                                                                                         |  |                    |             |   |                   |   |             |  
|Line of credit                                                                                                                                                                      |  | $                  | 16,228,232  |   |                   | $ | 3,500,000   |  
|Mortgage loans                                                                                                                                                                      |  |                    | 41,885,071  |   |                   |   | 42,686,943  |  
|Accounts payable and other accrued liabilities                                                                                                                                      |  |                    | 5,501,344   |   |                   |   | 5,106,882   |  
|Dividends and distributions payable                                                                                                                                                 |  |                    | 1,805,333   |   |                   |   | 1,803,973   |  
|Advance deposits                                                                                                                                                                    |  |                    | 560,673     |   |                   |   | 266,657     |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL LIABILITIES                                                                                                                                                                   |  |                    | 65,980,653  |   |                   |   | 53,364,455  |  
|Minority interest in operating partnership                                                                                                                                          |  |                    | 21,019,043  |   |                   |   | 21,805,572  |  
|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, 6,712,000 shares and 6,704,000 shares issued and outstanding at
September 30, 2006 and December 31, 2005, respectively |  |                    | 67,120      |   |                   |   | 67,040      |  
|Additional paid in capital                                                                                                                                                          |  |                    | 47,918,767  |   |                   |   | 47,760,347  |  
|Accumulated deficit                                                                                                                                                                 |  |                    | (5,961,887  | ) |                   |   | (4,611,491  | )
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL SHAREHOLDERS EQUITY                                                                                                                                                          |  |                    | 42,024,000  |   |                   |   | 43,215,896  |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  
|TOTAL LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                          |  | $                  | 129,023,696 |   |                   | $ | 118,385,923 |  
|                                                                                                                                                                                    |  |                    |             |   |                   |   |             |  

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



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##### Table of Contents

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)



|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|------------------------------------------------------------------------- |  | ------------------------------------- | ---------- | - | ------------------------------------- | - | ---------- | ------------------------------------ |  | - | ------------------------------------ | - |  | - | ---------- | -
|                                                                          |  | Three months ended September 30, 2006 |            |   | Three months ended September 30, 2005 |   |            | Nine months ended September 30, 2006 |  |   | Nine months ended September 30, 2005 |  
|REVENUE                                                                   |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Rooms department                                                          |  | $                                     | 10,670,222 |   |                                       | $ | 9,288,827  |                                      |  | $ | 33,474,763                           |   |  | $ | 26,145,790 |  
|Food and beverage department                                              |  |                                       | 4,352,351  |   |                                       |   | 3,656,040  |                                      |  |   | 13,937,662                           |   |  |   | 11,083,907 |  
|Other operating departments                                               |  |                                       | 1,095,163  |   |                                       |   | 684,990    |                                      |  |   | 2,833,972                            |   |  |   | 1,793,101  |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Total revenue                                                             |  |                                       | 16,117,736 |   |                                       |   | 13,629,857 |                                      |  |   | 50,246,397                           |   |  |   | 39,022,798 |  
|EXPENSES                                                                  |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Hotel operating expenses                                                  |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Rooms department                                                          |  |                                       | 2,956,682  |   |                                       |   | 2,662,937  |                                      |  |   | 9,231,870                            |   |  |   | 7,229,682  |  
|Food and beverage department                                              |  |                                       | 3,059,996  |   |                                       |   | 2,716,963  |                                      |  |   | 9,634,172                            |   |  |   | 7,751,987  |  
|Other operating departments                                               |  |                                       | 221,785    |   |                                       |   | 205,360    |                                      |  |   | 657,545                              |   |  |   | 531,124    |  
|Indirect                                                                  |  |                                       | 5,851,031  |   |                                       |   | 5,178,524  |                                      |  |   | 18,462,536                           |   |  |   | 14,542,215 |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Total hotel operating expenses                                            |  |                                       | 12,089,494 |   |                                       |   | 10,763,784 |                                      |  |   | 37,986,123                           |   |  |   | 30,055,008 |  
|Depreciation and amortization                                             |  |                                       | 1,211,386  |   |                                       |   | 1,055,091  |                                      |  |   | 3,599,640                            |   |  |   | 2,896,003  |  
|Corporate general and administrative                                      |  |                                       | 552,648    |   |                                       |   | 428,050    |                                      |  |   | 2,007,063                            |   |  |   | 1,393,217  |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Total operating expenses                                                  |  |                                       | 13,853,528 |   |                                       |   | 12,246,925 |                                      |  |   | 43,592,826                           |   |  |   | 34,344,228 |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|NET OPERATING INCOME                                                      |  |                                       | 2,264,208  |   |                                       |   | 1,382,932  |                                      |  |   | 6,653,571                            |   |  |   | 4,678,570  |  
|Other income (expense)                                                    |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Interest expense                                                          |  |                                       | (1,097,794 | ) |                                       |   | (834,470   | )                                    |  |   | (3,167,740                           | ) |  |   | (1,870,080 | )
|Interest income                                                           |  |                                       | 74,256     |   |                                       |   | 18,837     |                                      |  |   | 117,667                              |   |  |   | 120,494    |  
|Unrealized (loss) on hedging activities                                   |  |                                       | (231,870   | ) |                                       |   |           |                                      |  |   | (231,870                             | ) |  |   |           |  
|Gain on disposal of assets                                                |  |                                       | 126,664    |   |                                       |   |           |                                      |  |   | 126,664                              |   |  |   |           |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Income before minority interest in operating partnership and income taxes |  |                                       | 1,135,464  |   |                                       |   | 567,299    |                                      |  |   | 3,498,292                            |   |  |   | 2,928,984  |  
|Minority interest in operating partnership                                |  |                                       | (465,522   | ) |                                       |   | (308,308   | )                                    |  |   | (1,244,726                           | ) |  |   | (1,117,408 | )
|Benefit from (provision for) income taxes                                 |  |                                       | 129,591    |   |                                       |   | 271,983    |                                      |  |   | (117,012                             | ) |  |   | 123,920    |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Income from continuing operations                                         |  |                                       | 799,533    |   |                                       |   | 530,974    |                                      |  |   | 2,136,554                            |   |  |   | 1,935,496  |  
|Income (loss) from discontinued operations, net                           |  |                                       | (190       | ) |                                       |   | 64,068     |                                      |  |   | (65,870                              | ) |  |   | 20,151     |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|NET INCOME                                                                |  | $                                     | 799,343    |   |                                       | $ | 595,042    |                                      |  | $ | 2,070,684                            |   |  | $ | 1,955,647  |  
|                                                                          |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Continued operations per share                                            |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Basic                                                                     |  | $                                     | 0.12       |   |                                       | $ | 0.08       |                                      |  | $ | 0.32                                 |   |  | $ | 0.29       |  
|Diluted                                                                   |  | $                                     | 0.12       |   |                                       | $ | 0.08       |                                      |  | $ | 0.32                                 |   |  | $ | 0.29       |  
|Discontinued operations per share                                         |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Basic                                                                     |  | $                                     | (0.00      | ) |                                       | $ | 0.01       |                                      |  | $ | (0.01                                | ) |  | $ | 0.00       |  
|Diluted                                                                   |  | $                                     | (0.00      | ) |                                       | $ | 0.01       |                                      |  | $ | (0.01                                | ) |  | $ | 0.00       |  
|Net income (loss) per share                                               |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Basic                                                                     |  | $                                     | 0.12       |   |                                       | $ | 0.09       |                                      |  | $ | 0.31                                 |   |  | $ | 0.29       |  
|Diluted                                                                   |  | $                                     | 0.12       |   |                                       | $ | 0.09       |                                      |  | $ | 0.31                                 |   |  | $ | 0.29       |  
|Weighted average number of shares outstanding                             |  |                                       |            |   |                                       |   |            |                                      |  |   |                                      |   |  |   |            |  
|Basic                                                                     |  |                                       | 6,712,000  |   |                                       |   | 6,704,000  |                                      |  |   | 6,707,355                            |   |  |   | 6,655,282  |  
|Diluted                                                                   |  |                                       | 6,781,000  |   |                                       |   | 6,704,000  |                                      |  |   | 6,774,015                            |   |  |   | 6,655,282  |  

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



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##### Table of Contents

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY

(unaudited)



|                                           |  |              |  |                            |        |                     |   |            |       |   |            |   |  |   |            |  
|------------------------------------------ |  | ------------ |  | -------------------------- | ------ | ------------------- | - | ---------- | ----- | - | ---------- | - |  | - | ---------- | -
|                                           |  | Common Stock |  | Additional Paid-In Capital |        | Accumulated Deficit |   |            | Total |  
|                                           |  | Shares       |  | Par Value                  |        |                     |  
|Balances at December 31, 2005              |  | 6,704,000    |  | $                          | 67,040 |                     | $ | 47,760,347 |       | $ | (4,611,491 | ) |  | $ | 43,215,896 |  
|Issuance of restricted common stock awards |  | 8,000        |  |                            | 80     |                     |   | 72,920     |       |   |           |   |  |   | 73,000     |  
|Amortization of deferred stock grants      |  |              |  |                            |        |                     |   | 85,500     |       |   |           |   |  |   | 85,500     |  
|Net income                                 |  |              |  |                            |        |                     |   |            |       |   | 2,070,684  |   |  |   | 2,070,684  |  
|Dividends declared                         |  |              |  |                            |        |                     |   |            |       |   | (3,421,080 | ) |  |   | (3,421,080 | )
|                                           |  |              |  |                            |        |                     |   |            |       |   |            |   |  |   |            |  
|Balances at September 30, 2006             |  | 6,712,000    |  | $                          | 67,120 |                     | $ | 47,918,767 |       | $ | (5,961,887 | ) |  | $ | 42,024,000 |  
|                                           |  |              |  |                            |        |                     |   |            |       |   |            |   |  |   |            |  

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



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##### Table of Contents

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)



|                                                                                  |  |                                      |             |   |                                      |   |             |  
|--------------------------------------------------------------------------------- |  | ------------------------------------ | ----------- | - | ------------------------------------ | - | ----------- | -
|                                                                                  |  | Nine months Ended September 30, 2006 |             |   | Nine months ended September 30, 2005 |  
|Cash Flows from Operating Activities:                                             |  |                                      |             |   |                                      |   |             |  
|Net income                                                                        |  | $                                    | 2,070,684   |   |                                      | $ | 1,955,647   |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                                      |             |   |                                      |   |             |  
|Depreciation and amortization                                                     |  |                                      | 3,736,509   |   |                                      |   | 3,069,133   |  
|(Gain) loss on disposal of assets                                                 |  |                                      | (126,664    | ) |                                      |   |            |  
|Unrealized loss on hedging activities                                             |  |                                      | 231,870     |   |                                      |   |            |  
|Amortization of deferred financing costs                                          |  |                                      | 172,415     |   |                                      |   | 58,077      |  
|Charges related to equity-based compensation                                      |  |                                      | 158,500     |   |                                      |   |            |  
|Minority interest in operating partnership                                        |  |                                      | 1,206,350   |   |                                      |   | 1,129,040   |  
|Changes in assets and liabilities:                                                |  |                                      |             |   |                                      |   |             |  
|Restricted cash                                                                   |  |                                      | 128,564     |   |                                      |   | (1,006,932  | )
|Accounts receivable                                                               |  |                                      | (506,192    | ) |                                      |   | (862,847    | )
|Inventory, prepaid expenses and other assets                                      |  |                                      | (615,700    | ) |                                      |   | (1,024,454  | )
|Accounts payable and other accrued liabilities                                    |  |                                      | (69,384     | ) |                                      |   | (828,730    | )
|Advance deposits                                                                  |  |                                      | 294,016     |   |                                      |   | 72,429      |  
|Due from affiliates                                                               |  |                                      | 231,465     |   |                                      |   | 15,031      |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Net cash provided by operating activities                                         |  |                                      | 6,912,434   |   |                                      |   | 2,576,394   |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Cash flows from investing activities:                                             |  |                                      |             |   |                                      |   |             |  
|Acquisition of hotel properties                                                   |  |                                      | (7,696,353  | ) |                                      |   | (3,559,324  | )
|Improvements and additions to hotel properties                                    |  |                                      | (4,355,225  | ) |                                      |   | (6,144,653  | )
|Contribution to restricted capital improvement reserve                            |  |                                      |            |   |                                      |   | (3,000,000  | )
|Proceeds of restricted capital improvement reserve                                |  |                                      | 1,214,330   |   |                                      |   |            |  
|Proceeds from sale of hotel properties                                            |  |                                      | 162,459     |   |                                      |   |            |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Net cash used in investing activities                                             |  |                                      | (10,674,789 | ) |                                      |   | (12,703,977 | )
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Cash flows from financing activities:                                             |  |                                      |             |   |                                      |   |             |  
|Proceeds from sale of common stock                                                |  |                                      |            |   |                                      |   | 7,000,000   |  
|Payment of issuance costs related to sale of common stock                         |  |                                      |            |   |                                      |   | (490,000    | )
|Dividends and distributions paid                                                  |  |                                      | (5,412,600  | ) |                                      |   | (3,561,753  | )
|Proceeds from line of credit                                                      |  |                                      | 12,728,232  |   |                                      |   | 2,000,000   |  
|Payments on related party note                                                    |  |                                      |            |   |                                      |   | (2,000,000  | )
|Payment of deferred financing costs                                               |  |                                      | (622,751    | ) |                                      |   | (54,496     | )
|Payment of loans                                                                  |  |                                      | (801,872    | ) |                                      |   | (855,590    | )
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Net cash provided by (used in) financing activities                               |  |                                      | 5,891,010   |   |                                      |   | 2,038,161   |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Net increase (decrease) in cash and cash equivalents                              |  |                                      | 2,128,655   |   |                                      |   | (8,089,422  | )
|Cash and cash equivalents at the beginning of the period                          |  |                                      | 501,810     |   |                                      |   | 8,314,353   |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Cash and cash equivalents at the end of the period                                |  | $                                    | 2,630,465   |   |                                      | $ | 209,532     |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Supplemental disclosures:                                                         |  |                                      |             |   |                                      |   |             |  
|Cash paid during the period for interest                                          |  | $                                    | 2,936,748   |   |                                      | $ | 1,808,653   |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Cash paid for income taxes                                                        |  | $                                    | 349,231     |   |                                      | $ |            |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Purchase of property with debt                                                    |  | $                                    |            |   |                                      | $ | 18,000,000  |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Purchase of property for units in operating partnership                           |  | $                                    |            |   |                                      | $ | 913,482     |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  
|Sale of property for promissory notes                                             |  | $                                    | 4,430,000   |   |                                      | $ |            |  
|                                                                                  |  |                                      |             |   |                                      |   |             |  

The accompanying notes are an integral part of these financial statements



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##### Table of Contents

MHI HOSPITALITY CORPORATION

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Organization and Description of Business

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

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

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

On August 10, 2006, the Company sold the Holiday Inn Downtown, in Williamsburg, VA for $4.75
million. The Company agreed to take back three promissory notes that totaled $4.33 million from the purchaser and received the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on
December 31, 2006 with interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007. The third promissory note in the amount of $0.4 million with
interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. The Company has committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only
payments due monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes prior to maturity. The promissory notes are secured by a security interest in the
hotel and by personal guarantees of affiliates of the purchaser.

On September 20, 2006, the Company purchased the 186-room Louisville
Ramada Riverfront Inn, located in Jeffersonville, Indiana for approximately $7.7 million including transfer costs. The hotel is located directly on the Ohio River, with unimpeded views of the Louisville skyline, and easy access to the center of
downtown Louisville. The Company has closed the hotel to begin extensive renovations. The purchase was structured to meet the requirements of a Sec. 1031 like-kind exchange, enabling the company to defer tax on all capital gains on the sale in
August of its Williamsburg property. To facilitate the closing of the acquisition, MHI accessed approximately $7.5 million from its line of credit, and approximately $0.2 million in cash proceeds from the sale of its Williamsburg property.

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



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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, 2006 and 2005.

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

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

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

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

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

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

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

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, 2006, the Companys interest-rate swap agreement had an estimated fair value of $(463,844) and is included in accounts payable
and other accrued liabilities.



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##### Table of Contents

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, 2006 and December 31, 2005 were $190,383 and $208,308, respectively. Amortization expense totaled $6,229 and $21,021 for the three months and nine
months ended September 30, 2006, respectively, and $5,625 and $16,874 for the three and nine months ended September 30, 2005, respectively.

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

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

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

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.

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 81,000 shares including 69,000
shares granted under deferred stock awards to its executives, 4,000 restricted shares issued to certain employees, and 8,000 restricted shares issued to its directors. Of the 69,000 shares granted under deferred stock awards, 60,000 shares vest over
five years and 9,000 shares vest at the end of this year. Regarding the restricted shares awarded the Companys directors and certain employees, the shares vest immediately and represent compensation for the previous year of service. All such
shares are charged to compensation expense on a straight-line basis over the vesting or service period based on the Companys stock price on the date of grant or issuance. Under the Plan, the Company may issue a variety of performance-based
stock awards, including nonqualified stock options. As of September 30, 2006, no performance-based stock awards have been issued. Consequently, stock-based compensation as determined under the fair-value method would be the same under the
intrinsic-value method. Total compensation cost recognized under the Plan was $28,500 and $85,500 for the three months and nine months ended September 30, 2006, respectively and $0 for the three months and nine months ended September 30,
2005.

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

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



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

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

3. Acquisition of Hotel Properties

On September 20, 2006, the Company purchased the Louisville
Ramada Riverfront Inn, located in Jeffersonville, Indiana for approximately $7.7 million including transfer costs. The allocation of the purchase price to the acquired assets based on their fair values was as follows (in thousands):



|          |  |                                 |      
|--------- |  | ------------------------------- | -----
|          |  | Louisville RamadaRiverfront Inn
|Land      |  | $                               | 784  
|Buildings |  |                                 | 6,912
|          |  |                                 |      
|          |  | $                               | 7,696
|          |  |                                 |      

4. Investment in Hotel Properties

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



|                                  |  |                                               |         |   |                                              |   |         |  
|--------------------------------- |  | --------------------------------------------- | ------- | - | -------------------------------------------- | - | ------- | -
|                                  |  | MHI HospitalityCorporation September 30, 2006 |         |   | MHI HospitalityCorporation December 31, 2005 |  
|                                  |  | (unaudited)                                   |         |   |                                              |  
|Land and land improvements        |  | $                                             | 13,314  |   |                                              | $ | 12,513  |  
|Buildings and improvements        |  |                                               | 94,544  |   |                                              |   | 86,399  |  
|Furniture, fixtures and equipment |  |                                               | 22,362  |   |                                              |   | 19,629  |  
|                                  |  |                                               |         |   |                                              |   |         |  
|                                  |  |                                               | 130,220 |   |                                              |   | 118,541 |  
|Less: accumulated depreciation    |  |                                               | (20,225 | ) |                                              |   | (16,958 | )
|                                  |  |                                               |         |   |                                              |   |         |  
|                                  |  | $                                             | 109,995 |   |                                              | $ | 101,583 |  
|                                  |  |                                               |         |   |                                              |   |         |  

5. Credit Facility

As of September 30, 2006, the Company had a secured, revolving credit facility with a financial institution that enabled the Company to borrow up to $60 million, subject to borrowing base and loan-to-value
limitations, with a syndicated bank group comprising of Branch Banking & Trust Company (BB&T), Key Bank National Association, Regions Bank and Manufacturers and Traders Trust Company. The credit facility was established during second
quarter of 2006 and replaced a $23 million secured, revolving credit facility with BB&T. The Company had borrowings of $16,228,232 and $3,500,000 at September 30, 2006 and December 31, 2005, respectively.

The facility matures during May 2010 and bears interest at a floating rate of LIBOR plus additional interest ranging from 2.0% to 2.5%. On
September 30, 2006, LIBOR was 5.322%. In some circumstances, the revolving line of credit facility may bear interest at BB&Ts prime rate. Any amounts drawn under the revolving line of credit facility mature at the expiration of the
facility. The revolving line of credit facility includes an uncommitted accordion facility, pursuant to which the Company may be able to increase the total commitment under the revolving line of credit facility up to $75 million. The Company is
required to pay a fee of 0.25% on the unused portion of the credit facility. Under the terms of the agreement, the Company 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 and the Hilton Philadelphia Airport, and a lien on all business assets of those properties
including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. At September 30, 2006, the two properties had a net carrying value of approximately $35.4 million. Under the terms of the
BB&T line of credit, the Company must satisfy certain financial and non-financial covenants. As of September 30, 2006 and December 31, 2005, the Company was in compliance with all of the required covenants.



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6. Mortgage Debt

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

On September 25, 1998, Savannah Hotel Associates, LLC obtained a mortgage loan in the amount of $12.8 million to refinance the mortgage at the
Savannah DeSoto Hilton hotel. The loan is secured by the Savannah DeSoto Hilton hotel and its maturity date is November 1, 2008. Loan principal and interest payments are due monthly, with fixed principal payments plus interest amortized over a
twenty (20) year schedule. Interest is based on a fixed rate of 7.49%. Savannah Hotel Associates, LLC recorded deferred financing costs of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the
loan as of September 30, 2006 and December 31, 2005 was $9,811,272 and $10,175,989, respectively.

On February 12, 1998
Capitol Hotel Associates, LP, LLP obtained a mortgage loan in the amount of $13.0 million to refinance the mortgage at the Wilmington Riverside Hilton hotel. On October 19, 1999 Capitol Hotel Associates, LP, LLP obtained a promissory note in
the amount of $4.25 million upon completion of construction of renovations. The debt was consolidated into one instrument and is secured by the Wilmington Riverside Hilton hotel and its maturity date is March 1, 2008. Loan principal and
interest payments are due monthly, with fixed principal payments and interest payments amortized over a twenty (20) year schedule. Interest is based on a fixed rate of 8.22%. Capitol Hotel Associates, LP, LLP recorded deferred financing costs
of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the loan as of September 30, 2006 and December 31, 2005 was $14,073,799 and $14,510,954, respectively.

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

Total mortgage debt maturities as of September 30, 2006 for the following twelve-month periods were as follows ($000s):



|                   |  |   |       
|------------------ |  | - | ------
|September 30, 2007 |  | $ | 1,145 
|September 30, 2008 |  |   | 14,007
|September 30, 2009 |  |   | 8,733 
|September 30, 2010 |  |   | 18,000
|                   |  |   |       
|Total              |  | $ | 41,885
|                   |  |   |       

7. Commitments and Contingencies

Ground, Building and Submerged Land Leases  The Company leases 2,086 square feet of commercial space next to the Savannah hotel property for
use as an office, retail or conference space, or for any related or ancillary purposes for the hotel and/or atrium space. The space is leased under a six-year operating lease, which expires October 31, 2006. There is a renewal option for up to
three five-year periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for this operating lease was $10,795 and $32,385 for the three months and nine months ended September 30,
2006, respectively and $9,387 and $28,161 for the three months and nine months ended September 30, 2005, respectively.

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

The Company leases a parking lot adjacent to the Holiday Inn Brownstone in Raleigh, North Carolina. The land is leased under a second
amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a 50-year operating lease, which expires August 31, 2016. There is a renewal option for up to three additional ten-year periods
expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. The Company holds an exclusive and irrevocable option to purchase the leased land at fair market value at the end of the original lease term, subject
to the payment



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of an annual fee of $9,000, and other conditions. For the three months ended September 30, 2006 and 2005, rent
expense was $19,351 and $19,026, respectively. For the nine months ended September 30, 2006 and 2005, rent expense was $57,943 and $57,078, respectively.

In conjunction with the sublease arrangement for the property at Shell Island, the Company incurs an annual lease expense for a leasehold interest other than the purchased leasehold interest. Lease expense was $47,819
and $128,032 for the three months and nine months ended September 30, 2006, respectively, and $33,319 and $117,847 for the three months and nine months ended September 30, 2005, respectively.

The Company leases certain submerged land in the Saint Johns River in front of the Crowne Plaza Jacksonville Hotel from the Board of Trustees of the
Internal Improvement Trust Fund of the State of Florida. The submerged land is leased under a five-year operating lease, which expires September 18, 2007. Rent expense for the three months and nine months ended September 30, 2006 was
$1,160 and $3,479, respectively. Rent expense for the three months and nine months ended September 30, 2005 was $940.

The Company
leases 1,890 square feet of commercial office space in Williamsburg, Virginia under a two-year agreement that expires August 31, 2008. There is a one-year renewal option. For the three months and nine months ended September 30, 2006 rent
expense was $3,465.

Purchase Agreement  On September 13, 2005, the Company entered into an agreement to purchase the
commercial space of a condominium project in Hollywood, Florida last operated as the Ambassador Resort. The agreement, as amended, requires the Company to purchase the common space within the condominium as well as two additional condominium units
for $1.35 million. The developer of the property is completing a condominium conversion after which time the Company will retain MHI Hotels Services to operate the hotel. The Company may also be required by the developer to purchase a maximum of 100
additional condominium units on or before August 1, 2007 at a maximum price of $197,000 per unit pursuant to certain terms and conditions.

Management Agreement  Each of the seven hotels that the Company owned at September 30, 2006 operate under a ten-year master management agreement with MHI Hotels Services that expire between December 2014 and July 2015 (see
Note 9).

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

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

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

8. Capital Stock

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

On December 21, 2004, the Company completed its IPO and sold 6,000,000 shares of common stock at a price of $10 per share, resulting in gross
proceeds of $60 million and net proceeds (after deducting underwriting discounts and offering expenses) of approximately $54.8 million. On December 21, 2004 the Company issued 4,000 shares of common stock to its independent directors. On
January 19, 2005, the Company sold an additional 700,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the exercise of the underwriters over-allotment option, resulting in
additional net proceeds of approximately $6.5 million. The total net proceeds generated from the IPO and the underwriters over-allotment was approximately $61.3 million. In June 2006, the Company issued 8,000 shares of restricted common stock
to its independent directors and non-executive employees. As of September 30, 2006, the Company had 6,712,000 shares of common stock outstanding.



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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, 2006, there were no shares of preferred stock outstanding.

Operating Partnership Units  Holders of
Operating Partnership units have certain redemption rights, which enable them to cause the Operating Partnership to redeem their units in exchange for shares of the Companys common stock on a one-for-one basis or, at the option of the Company,
cash per unit equal to the market price of the Companys common stock at the time of redemption. The number of shares issuable upon exercise of the redemption rights will be adjusted upon the occurrence of stock splits, mergers, consolidations
or similar pro-rata share transactions, which otherwise would have the effect of diluting the ownership interests of the limited partners or the stockholders of the Company. As of September 30, 2006, the total number of Operating Partnership
units outstanding was 3,907,607.

9. Related Party Transactions

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

Accounts
Receivable At September 30, 2006 and December 31, 2005, the Company was due $10,897 and $242,362, respectively, from MHI Hotels Services.

Shell Island Sublease  The Company has a sublease arrangement with MHI Hotels Services on its leasehold interests in the property at Shell Island. For the three months ended September 30, 2006 and
2005, the Company earned $160,000 in leasehold revenue. For the nine months ended September 30, 2006 and 2005, the Company earned $480,000 in leasehold revenue.

Sublease of Office Space The Company subleases office space in Greenbelt, MD from MHI Hotels Services. Rent expense was $10,030 and $28,570 for the three months and nine months ended September 30,
2006, respectively and $10,320 and $22,250 for the three months and nine months ended September 30, 2005, respectively.

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

Management Agreements Each of the seven hotels that the Company owned at
September 30, 2006 are operated by MHI Hotels Services under a master management agreement that expire between December 2014 and July 2015. MHI Hotels Services receives a base management fee, and if the hotels meet and exceed certain
thresholds, an additional incentive management fee. The base management fee for the initial portfolio of six hotels was 2.0% in 2005, rising to 2.5% in 2006 and 3.0% thereafter of total gross revenues from the hotels. The base management fee for the
Crowne Plaza Jacksonville Hotel is 2.0% through 2006, rising to 2.5% in 2007 and 3.0% thereafter. Pursuant to the sale of the Holiday Inn Dowtown in Williamsburg, Virginia, one of the hotels initially contributed to the Company upon its formation,
MHI Hotels Services has agreed that the Louisville Ramada Riverfront Inn in Jeffersonville, Indiana, shall be substituted for the Williamsburg property under the master management agreement. 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 individual basis, for a given year exceeds the gross operating profit for the same hotels, on an
individual basis, for the prior year. The incentive management fee may not exceed 0.25% of gross revenue of the individual hotel that qualifies for incentive fee.

The Company paid MHI Hotels Services approximately $0.395 million and $1.239 million for the three months and nine months ended September 30, 2006, respectively, and approximately $0.289 million and $0.816
million for the three months and nine months ended September 30, 2005, respectively, in management fees. In addition, estimated incentive management fees of approximately $0.063 million and $0 million were accrued, but not paid, as of
September 30, 2006 and 2005, 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. The Company paid $18,708 and $56,801 for the three months and nine months ended September 30, 2006, respectively and $10,115 and $26,750 for the three
months and nine months ended September 30, 2005, respectively for benefits.

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



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Construction Management Services  The Company engaged MHI Hotels Services to manage the
renovation of the Crowne Plaza Jacksonville. For the three months and nine months ended September 30, 2006, the company paid $0 and $112,000 in construction management fees. In addition, the Company has engaged MHI Hotels Services to manage the
renovation of the property in Jeffersonville, Indiana. It is estimated that the construction management fee will total $550,000.

10. Income Taxes

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



|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|--------- |  | ------------------------------------ | ---- | - | ------------------------------------ | - | ---- | ----------------------------------- |  | - | ----------------------------------- | - |  | - | ---- | -
|          |  | Three Months EndedSeptember 30, 2006 |      |   | Three Months EndedSeptember 30, 2005 |   |      | Nine Months EndedSeptember 30, 2006 |  |   | Nine Months EndedSeptember 30, 2005 |  
|          |  | (unaudited)                          |      |   | (unaudited)                          |   |      | (unaudited)                         |  |   | (unaudited)                         |  
|Current:  |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|Federal   |  | $                                    |     |   |                                      | $ |     |                                     |  | $ |                                    |   |  | $ |     |  
|State     |  |                                      | 76   |   |                                      |   | (26  | )                                   |  |   | 363                                 |   |  |   | 25   |  
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|          |  |                                      | 76   |   |                                      |   | (26  | )                                   |  |   | 363                                 |   |  |   | 25   |  
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|Deferred: |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|Federal   |  |                                      | (215 | ) |                                      |   | (245 | )                                   |  |   | (318                                | ) |  |   | (190 | )
|State     |  |                                      | (52  | ) |                                      |   | (21  | )                                   |  |   | (82                                 | ) |  |   | (74  | )
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|          |  |                                      | (267 | ) |                                      |   | (266 | )                                   |  |   | (400                                | ) |  |   | (264 | )
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  
|          |  | $                                    | (191 | ) |                                      | $ | (292 | )                                   |  | $ | (37                                 | ) |  | $ | (239 | )
|          |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |      |  

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, 2006 |      |   | Three Months EndedSeptember 30, 2005 |   |      | Nine Months EndedSeptember 30, 2006 |  |   | Nine Months EndedSeptember 30, 2005 |  
|                                     |  | (unaudited)                          |      |   | (unaudited)                          |   |      | (unaudited)                         |  |   | (unaudited)                         |  
|Statutory federal income tax expense |  | $                                    | 365  |   |                                      | $ | 220  |                                     |  | $ | 1,167                               |   |  | $ | 967    |  
|Effect of non-taxable REIT income    |  |                                      | (530 | ) |                                      |   | (460 | )                                   |  |   | (1,487                              | ) |  |   | (1,156 | )
|State income tax expense             |  |                                      | (26  | ) |                                      |   | (52  | )                                   |  |   | 281                                 |   |  |   | (50    | )
|                                     |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |        |  
|                                     |  | $                                    | (191 | ) |                                      | $ | (292 | )                                   |  | $ | (37                                 | ) |  | $ | (239   | )
|                                     |  |                                      |      |   |                                      |   |      |                                     |  |   |                                     |   |  |   |        |  

As of September 30, 2006, the Company had a net deferred tax asset of approximately $1.1
million, primarily due to past years net operating loss. These loss carryforwards will begin to expire in 2024 if not utilized by then. The Company believes that is more likely than not that the deferred tax asset will be realized and that no
valuation allowance is required.

11. Discontinued Operations

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

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



14



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##### Table of Contents

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



|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|------------------------------------------ |  | ------------------------------------ | ------- | - | ------------------------------------ | - | ------- | ----------------------------------- |  | - | ----------------------------------- | - |  | - | --------- | -
|                                           |  | Three months endedSeptember 30, 2006 |         |   | Three months endedSeptember 30, 2005 |   |         | Nine months endedSeptember 30, 2006 |  |   | Nine months endedSeptember 30, 2005 |  
|                                           |  | (unaudited)                          |         |   | (unaudited)                          |   |         | (unaudited)                         |  |   | (unaudited)                         |  
|Revenue                                    |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Rooms department                           |  | $                                    | 435,001 |   |                                      | $ | 703,612 |                                     |  | $ | 1,304,020                           |   |  | $ | 1,641,743 |  
|Food and beverage department               |  |                                      | 96,465  |   |                                      |   | 198,770 |                                     |  |   | 456,148                             |   |  |   | 570,591   |  
|Other operating departments                |  |                                      | 16,020  |   |                                      |   | 25,419  |                                     |  |   | 34,132                              |   |  |   | 48,362    |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Total revenue                              |  |                                      | 547,486 |   |                                      |   | 927,801 |                                     |  |   | 1,794,300                           |   |  |   | 2,260,696 |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Expenses                                   |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Hotel operating expenses                   |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Rooms department                           |  |                                      | 154,234 |   |                                      |   | 204,316 |                                     |  |   | 516,887                             |   |  |   | 520,445   |  
|Food and beverage department               |  |                                      | 124,360 |   |                                      |   | 201,441 |                                     |  |   | 473,018                             |   |  |   | 551,740   |  
|Other operating departments                |  |                                      | 6,108   |   |                                      |   | 25,994  |                                     |  |   | 25,296                              |   |  |   | 47,936    |  
|Indirect                                   |  |                                      | 321,591 |   |                                      |   | 353,001 |                                     |  |   | 900,845                             |   |  |   | 1,051,079 |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Total hotel operating expenses             |  |                                      | 606,293 |   |                                      |   | 784,752 |                                     |  |   | 1,916,046                           |   |  |   | 2,171,200 |  
|Depreciation and amortization              |  |                                      | 2,028   |   |                                      |   | 62,135  |                                     |  |   | 136,869                             |   |  |   | 173,130   |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Total operating expenses                   |  |                                      | 608,320 |   |                                      |   | 846,888 |                                     |  |   | 2,052,914                           |   |  |   | 2,344,329 |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Net operating income (loss)                |  |                                      | (60,834 | ) |                                      |   | 80,914  |                                     |  |   | (258,614                            | ) |  |   | (83,633   | )
|Minority interest in operating partnership |  |                                      | 97      |   |                                      |   | (36,915 | )                                   |  |   | 38,375                              |   |  |   | (11,634   | )
|Income tax (provision) benefit             |  |                                      | 60,547  |   |                                      |   | 20,068  |                                     |  |   | 154,369                             |   |  |   | 115,417   |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  
|Net income from discontinued operations    |  | $                                    | (190    | ) |                                      | $ | 64,068  |                                     |  | $ | (65,870                             | ) |  | $ | 20,151    |  
|                                           |  |                                      |         |   |                                      |   |         |                                     |  |   |                                     |   |  |   |           |  

12. Earnings per Share



|                                                          |  |                                      |           |                                      |   |                                     |  |                                     |           |  |   |          
|--------------------------------------------------------- |  | ------------------------------------ | --------- | ------------------------------------ | - | ----------------------------------- |  | ----------------------------------- | --------- |  | - | ---------
|                                                          |  | Three months endedSeptember 30, 2006 |           | Three months endedSeptember 30, 2005 |   | Nine months endedSeptember 30, 2006 |  | Nine months endedSeptember 30, 2005
|                                                          |  | (unaudited)                          |           | (unaudited)                          |   | (unaudited)                         |  | (unaudited)                        
|Net income                                                |  | $                                    | 799,343   |                                      | $ | 595,042                             |  | $                                   | 2,070,684 |  | $ | 1,955,647
|Basic:                                                    |  |                                      |           |                                      |   |                                     |  |                                     |           |  |   |          
|Weighted average number of common shares outstanding      |  |                                      | 6,712,000 |                                      |   | 6,704,000                           |  |                                     | 6,707,355 |  |   | 6,655,282
|Net income per share - basic                              |  | $                                    | 0.12      |                                      | $ | 0.09                                |  | $                                   | 0.31      |  | $ | 0.29     
|Diluted:                                                  |  |                                      |           |                                      |   |                                     |  |                                     |           |  |   |          
|Dilutive awards                                           |  |                                      | 69,000    |                                      |   |                                    |  |                                     | 69,000    |  |   |         
|Diluted weighted average number common shares outstanding |  |                                      | 6,781,000 |                                      |   | 6,704,000                           |  |                                     | 6,774,015 |  |   | 6,655,282
|Net income per share - diluted                            |  | $                                    | 0.12      |                                      | $ | 0.09                                |  | $                                   | 0.31      |  | $ | 0.29     

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

13. Subsequent Events

On October 11, 2006, the Company paid the dividend for the second quarter of 2006 that was authorized on July 17, 2006 to those stockholders and unitholders of MHI Hospitality, L.P. of record on September 15, 2006. The
dividend was $0.17 per share (unit).

On October 16, 2006, the Company authorized the payment of a quarterly dividend of $0.17 per
share (unit) to the stockholders and unitholders of record as of December 15, 2006. The dividend is to be paid January 11, 2007.



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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 current and future opportunities in
the full-service, upper upscale, upscale and mid-scale segments of the hotel industry. We commenced operations in December 2004 when we completed our initial public offering.

Concurrent with the completion of the IPO, we acquired six hotel properties. Our hotel portfolio currently consists of seven full-service, upper upscale
and mid-scale hotels. The most recent addition to our portfolio, the Louisville Ramada Riverfront Inn was acquired on September 20, 2006. It is currently being renovated and is expected to be re-branded and to re-open in the third quarter 2007.
We own a 100% interest in all of our hotels. We also have a leasehold interest in a resort condominium facility and have entered into a purchase agreement to acquire an interest in a condominium hotel project in Hollywood, Florida. As of
September 30, 2006, we owned the following hotel properties:



|                                 |  |                 |  |                    |  |                    
|-------------------------------- |  | --------------- |  | ------------------ |  | -------------------
|Property                         |  | Number of Rooms |  | Location           |  | Date of Acquisition
|Hilton Philadelphia Airport      |  | 331             |  | Philadelphia, PA   |  | December 21, 2004  
|Holiday Inn Laurel West          |  | 207             |  | Laurel, MD         |  | December 21, 2004  
|Holiday Inn Brownstone           |  | 187             |  | Raleigh, NC        |  | December 21, 2004  
|Hilton Wilmington Riverside      |  | 274             |  | Wilmington, NC     |  | December 21, 2004  
|Hilton Savannah DeSoto           |  | 246             |  | Savannah, GA       |  | December 21, 2004  
|Crowne Plaza Jacksonville        |  | 292             |  | Jacksonville, FL   |  | July 22, 2005      
|Louisville Ramada Riverfront Inn |  | 186             |  | Jeffersonville, IN |  | September 20,2006  
|                                 |  |                 |  |                    |  |                    
|Total                            |  | 1,723           |  |                    |  |                    
|                                 |  |                 |  |                    |  |                    

On August 10, 2006, we sold the Holiday Inn Downtown, in Williamsburg, VA for $4.75 million.
We took back three promissory notes totaling $4.33 million from the purchaser and received the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with
interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007 at the election of the purchaser. The third note in the amount of $0.4 million with
interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. We have committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due
monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes are secured by a security interest in the hotel and by personal
guarantees of affiliates of the purchaser.

We conduct substantially all our business through our operating partnership, MHI Hospitality,
L.P. We are the sole general partner of our operating partnership and we own an approximate 63.2% interest in our operating partnership, with the remaining interest being held by the contributors of our initial properties as limited partners.

On September 20, 2006, we purchased the 186-room Louisville Ramada Riverfront Inn, located in Jeffersonville, Indiana for
approximately $7.7 million including transfer costs. The hotel is located directly on the Ohio River, with unimpeded views of the Louisville skyline, and easy access to the center of downtown Louisville. We intend to extensively renovate and
re-brand the hotel, as is consistent with our repositioning strategy. We structured the purchase to meet the requirements of a Sec. 1031 like-kind exchange, enabling us to defer tax on all capital gains on the sale in August of our Williamsburg
property. To facilitate the closing of the acquisition, we accessed approximately $7.5 million from the line of credit, and approximately $0.2 million in cash proceeds from the sale of the Williamsburg property.

On September 13, 2005 we entered into an agreement to purchase an interest in a condominium hotel property in Hollywood, Florida last operated as
the Ambassador Resort. The seller will renovate the hotel and complete a condominium conversion. We will retain MHI Hotels Services, LLC (MHI Hotels Services) to manage the hotel on our behalf. Purchase of the interest in the property
and costs related to pre-opening expenses are expected to be incurred in the fourth quarter of this year and total approximately $3.8 million. In addition, we may be required by the developer to purchase a maximum of 100 un-sold condominium units on
or before August 1, 2007 at a maximum price of $197,000 per unit subject to certain terms and conditions.

To qualify as a REIT, we
cannot operate hotels. Therefore, our operating partnership leases our hotel properties to MHI Hospitality TRS, LLC, our TRS Lessee. Our TRS Lessee has engaged MHI Hotels Services to manage our hotels. Our TRS Lessee, and its parent, MHI Hospitality
TRS Holding, Inc., are consolidated into our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.



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##### Table of Contents

Key Operating Metrics

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



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



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



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

Results of Operations

The following table
illustrates the key operating metrics for the three months and nine months ended September 30, 2006 and 2005 for the properties owned by the Company during the respective reporting periods. Accordingly, the operations of the Crowne Plaza
Jacksonville Hotel are reflected only for the portion of the three-month and nine-month periods ended September 30, 2005 after July 22, 2005. In addition, the operations of the Holiday Inn Downtown in Williamsburg, Virginia are presented
only through August 10, 2006.



|                      |  |                                      |         |   |                                       |   |         |                                      |  |   |                                      |   |  |   |         |  
|--------------------- |  | ------------------------------------ | ------- | - | ------------------------------------- | - | ------- | ------------------------------------ |  | - | ------------------------------------ | - |  | - | ------- | -
|                      |  | Three months endedSeptember 30, 2006 |         |   | Three months ended September 30, 2005 |   |         | Nine months ended September 30, 2006 |  |   | Nine months ended September 30, 2005 |  
|Occupancy %           |  |                                      | 68.5    | % |                                       |   | 66.8    | %                                    |  |   | 69.9                                 | % |  |   | 69.6    | %
|ADR                   |  | $                                    | 110.37  |   |                                       | $ | 101.25  |                                      |  | $ | 110.59                               |   |  | $ | 100.35  |  
|RevPAR                |  | $                                    | 75.62   |   |                                       | $ | 67.62   |                                      |  | $ | 77.34                                |   |  | $ | 69.86   |  
|Available Room Nights |  |                                      | 146,864 |   |                                       |   | 147,784 |                                      |  |   | 449,677                              |   |  |   | 397,745 |  

In addition, the table below illustrates the same metrics as they pertain to the six properties in
our current portfolio that were open and operating at the end of September 2006 for both periods. The 2005 figures reflect the performance of the Crowne Plaza Jacksonville under previous ownership. That hotel was managed by MHI Hotels Services
throughout 2005.



|                      |  |                                       |         |   |                                       |   |         |                                      |  |   |                                      |   |  |   |         |  
|--------------------- |  | ------------------------------------- | ------- | - | ------------------------------------- | - | ------- | ------------------------------------ |  | - | ------------------------------------ | - |  | - | ------- | -
|                      |  | Three months ended September 30, 2006 |         |   | Three months ended September 30, 2005 |   |         | Nine months ended September 30, 2006 |  |   | Nine months ended September 30, 2005 |  
|Occupancy %           |  |                                       | 67.9    | % |                                       |   | 67.6    | %                                    |  |   | 71.1                                 | % |  |   | 72.0    | %
|ADR                   |  | $                                     | 111.08  |   |                                       | $ | 102.03  |                                      |  | $ | 112.20                               |   |  | $ | 103.40  |  
|RevPAR                |  | $                                     | 75.46   |   |                                       | $ | 68.96   |                                      |  | $ | 79.78                                |   |  | $ | 74.45   |  
|Available Room Nights |  |                                       | 141,404 |   |                                       |   | 141,404 |                                      |  |   | 419,601                              |   |  |   | 419,601 |  

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

Revenue. Total revenue for the three months ended September 30, 2006 was approximately $16.1 million, an increase of
approximately $2.5 million or 18.3% from the three months ended September 30, 2005. The largest increase in revenue was from room revenues, which, for the three months ended September 30, 2006 rose to approximately $10.7 million, an
increase of approximately $1.4 million or 14.9% compared to room revenues for the three months ended September 30, 2005. A new mix of business, a strong market, and the completion of room renovations caused a significant increase in ADR at our
Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also contributed to the significant increase in ADR at that property. These factors helped offset occupancy declines at our
Savannah and Jacksonville properties.

The six properties whose operating results are reflected in income from continuing operations were
able to achieve a 14.9% increase in room revenue through a combined 0.9% increase in occupancy, a 8.9% increase in ADR and a 5.4% increase in the number of room nights sold. The increase in room night sold resulted from the inclusion of the
operating results of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005 for the full three months ended September 30, 2006 versus operating results from that hotel being reflected in the third quarter 2005 only from the date
of acquisition.



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##### Table of Contents

Food and beverage revenues for the three months ended September 30, 2006 increased approximately
$0.7 million or 19.0% to approximately $4.4 million compared to food and beverage revenues for the three months ended September 30, 2005.

Revenue from other operating departments for the three months ended September 30, 2006 increased approximately $0.4 million or 59.9% to approximately $1.1 million compared to revenue from other operating departments of approximately
$0.7 million for the three months ended September 30, 2005. Commencing November 2005, we realized revenue from the lease of restaurant space at the Holiday Inn Laurel West that had undergone ten months of renovation. In addition, we were paid
consulting fees by the developer of the Hollywood, Florida condominium project in the third quarter of 2006.

Hotel Operating
Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees were approximately $12.1 million, an increase of approximately $1.3 million or 12.3% for the three months
ended September 30, 2006 compared to approximately $10.8 million for the three months ended September 30, 2005.

Rooms expense
for the three months ended September 30, 2006 increased approximately $0.3 million or 11% to approximately $3.0 million compared to rooms expense of approximately $2.7 million for the three months ended September 30, 2005. Much of the
increase relates to increased expenses at our Hilton brand properties for replacing room amenities as well as the increased cost of implementing a franchisor-mandated bedding program.

Food and beverage expenses for the three months ended September 30, 2006 increased approximately $0.3 million or 12.6% to approximately $3.1 million
compared to food and beverage expense for the three months ended September 30, 2005. The higher food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the three months
ended September 30, 2006 increased approximately $0.7 million or 13.0% to approximately $5.9 million compared to the three months ended September 30, 2005. Certain of the indirect expenses vary directly with increases in revenue.
Accordingly, we saw significant increases in sales and marketing expenses, hotel franchising fees and management fees.

Depreciation and
Amortization. Depreciation and amortization expense for the three months ended September 30, 2006 was approximately $1.2 million, an increase of approximately $0.1 million or 14.8% compared to approximately $1.1 million for the three months
ended September 30, 2005.

Corporate General and Administrative. Corporate general and administrative expenses for the three
months ended September 30, 2006 increased approximately $0.1 million or 29.1% compared to approximately $0.4 million for the three months ended September 30, 2005. The hiring of our Chief Operating Officer in January 2006 contributed to
the increase.

Interest Expense. Interest expense for the three months ended September 30, 2006 increased approximately $0.3
million or 31.6% to approximately $1.1 million compared to interest expense for the three months ended September 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of
credit.

Income Taxes. The net income tax benefit for the three months ended September 30, 2006 decreased to approximately $0.1
million. The income tax benefit is primarily derived from the net operating loss of our TRS lessee. The net operating loss of our TRS lessee attributable to continuing operations for the three months ended September 30, 2006 was less than the
net operating loss attributable to continuing operations for the three months ended September 30, 2005.

Net Income. The net
income for the three months ended September 30, 2006 increased approximately $0.2 million compared to the three months ended September 30, 2005 as a result of the operating results discussed above.

Comparison of Nine Months Ended September 30, 2006 to Nine Months Ended September 30, 2005

Revenue. Total revenue for the nine months ended September 30, 2006 was approximately $50.2 million, an increase of approximately $11.2
million or 28.8%, compared to the nine months ended September 30, 2005. Approximately $6.7 million in incremental revenues were attributable to the operating results of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005. The
remainder of the increase was due to improvements in all revenue categories.

Room revenues for the nine months ended September 30,
2006 rose to approximately $33.5 million, an increase of approximately $7.3 million or 28.0% compared to room revenues for the nine months ended September 30, 2005. Approximately $4.3 million of the increase was attributable to the operating
results of the Crowne Plaza Jacksonville Hotel. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is



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##### Table of Contents

not included in the presentation of continuing operations) increased approximately $3.0 million or 12.3%. A new mix of
business, a strong market, and the completion of room renovations caused a significant increase in ADR at our Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also
contributed to the significant increase in ADR at that property. These factors helped offset occupancy declines at our Savannah property.

Overall, our six operational properties were able to achieve a 7.3% increase in room revenue despite a 1.3% decline in occupancy by achieving an 8.5% increase in ADR over the same period.

Food and beverage revenues for the nine months ended September 30, 2006 increased approximately $2.9 million or 25.7% to approximately $13.9 million
compared to food and beverage revenues for the nine months ended September 30, 2005. Approximately $1.9 million of the increase was attributable to the operating results of the Crowne Plaza Jacksonville Hotel.

Revenue from other operating departments for the nine months ended September 30, 2006 increased approximately $1.0 million or 58.0% to approximately
$2.8 million compared to approximately $1.8 million in revenue from other operating departments for the nine months ended September 30, 2005. Approximately $0.6 million of the increase was attributable to the operating results of the Crowne
Plaza Jacksonville Hotel. As previously stated, the lease of restaurant space beginning November 2005 at of the Holiday Inn Laurel West subsequent to its renovation, as well as consulting fees received from the developer of the Hollywood, Florida
condominium project, also 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 $38.0 million, an increase of approximately $8.0 million or 26.4% for the nine months ended September 30, 2006 compared to
approximately $30.0 million for the nine months ended September 30, 2005, primarily due to approximately $5.2 million in incremental expense attributable to the Crowne Plaza Jacksonville Hotel acquired in July 2005.

Rooms expense for the nine months ended September 30, 2006 increased approximately $2.0 million or 27.7% to approximately $9.2 million compared to
rooms expense of approximately $7.2 million for the nine months ended September 30, 2005 primarily due to the operating results of the Crowne Plaza Jacksonville Hotel. Much of the remaining increase relates to increased expenses at our Hilton
brand properties for replacing room amenities as well as the increased cost of implementing a franchisor-mandated bedding program.

Food
and beverage expenses for the nine months ended September 30, 2006 increased approximately $1.9 million or 24.3% to approximately $9.6 million compared to food and beverage expense for the nine months ended September 30, 2005. The higher
food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the nine months ended September 30, 2006 increased approximately $3.9 million or 27.0% to approximately $18.5
million compared to the nine months ended September 30, 2005, primarily due to the acquisition of the Crowne Plaza Jacksonville Hotel. Sales and marketing expenses, hotel franchise fees and management fees increased significantly as these
expenses vary directly with increases in revenue.

Depreciation and amortization. Depreciation and amortization expense for the nine
months ended September 30, 2006 was approximately $3.6 million, an increase of approximately $0.7 million or 24.3% compared to approximately $2.9 million for the nine months ended September 30, 2005. The increase in depreciation and
amortization was attributable to the addition of depreciable assets including the Crowne Plaza Jacksonville Hotel and the renovations at our Philadelphia and Laurel properties.

Corporate General and Administrative. Corporate general and administrative expenses for the nine months ended September 30, 2006 increased
approximately $0.6 million or 44.1% compared to the nine months ended September 30, 2005 to approximately $2.0 million. Increased staffing levels, including the hiring of our Chief Operating Officer in January 2006 and our Chief Accounting
Officer in May 2005, as well as an accelerated timetable for the preparation of the Companys tax returns contributed to the increase.

Interest Expense. Interest expense for the nine months ended September 30, 2006 increased approximately $1.3 million or 69.4% to approximately $3.2 million compared to interest expense for the same period ended
September 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of credit.

Income Taxes. The net income tax provision for the nine months ended September 30, 2006 swung from an income tax benefit of approximately $0.1 million to a provision of approximately $0.1 million. The
income tax provision is primarily derived from the taxable income of our TRS lessee. The TRS lessee produced taxable income attributable to continuing operations for the nine months ended September 30, 2006 rather than a net operating loss that
was attributable to continuing operations for the nine months ended September 30, 2005.



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

Funds
From Operations

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

Management believes that the use of FFO, combined with the required GAAP presentations, has improved the understanding of the operating results of REITs
among the investing public and made comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure of adjusted net income for reviewing comparative operating and financial performance because we believe FFO is
most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset
depreciation and amortization, FFO assists in comparing the 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, 2006 and 2005 (unaudited):



|                                    |  |                                       |            |   |                                       |   |                                      |  |   |                                      |   |  |   |           
|----------------------------------- |  | ------------------------------------- | ---------- | - | ------------------------------------- | - | ------------------------------------ |  | - | ------------------------------------ | - |  | - | ----------
|                                    |  | Three months ended September 30, 2006 |            |   | Three months ended September 30, 2005 |   | Nine months ended September 30, 2006 |  |   | Nine months ended September 30, 2005
|Net income                          |  | $                                     | 799,343    |   |                                       | $ | 595,042                              |  | $ | 2,070,684                            |   |  | $ | 1,955,647 
|Add minority interest               |  |                                       | 465,425    |   |                                       |   | 345,222                              |  |   | 1,206,350                            |   |  |   | 1,129,040 
|Add depreciation and amortization   |  |                                       | 1,213,413  |   |                                       |   | 1,117,226                            |  |   | 3,736,509                            |   |  |   | 3,069,133 
|Less gain on sale of assets         |  |                                       | (126,664   | ) |                                       |   |                                     |  |   | (126,664                             | ) |  |   |          
|                                    |  |                                       |            |   |                                       |   |                                      |  |   |                                      |   |  |   |           
|FFO                                 |  | $                                     | 2,351,517  |   |                                       | $ | 2,057,490                            |  | $ | 6,886,879                            |   |  | $ | 6,153,820 
|                                    |  |                                       |            |   |                                       |   |                                      |  |   |                                      |   |  |   |           
|Weighted average shares outstanding |  |                                       | 6,712,000  |   |                                       |   | 6,704,000                            |  |   | 6,707,355                            |   |  |   | 6,655,282 
|Weighted average units outstanding  |  |                                       | 3,907,607  |   |                                       |   | 3,886,932                            |  |   | 3,907,607                            |   |  |   | 3,840,591 
|                                    |  |                                       |            |   |                                       |   |                                      |  |   |                                      |   |  |   |           
|Weighted average shares and units   |  |                                       | 10,619,607 |   |                                       |   | 10,590,932                           |  |   | 10,614,962                           |   |  |   | 10,495,873
|                                    |  |                                       |            |  
|FFO per share and unit              |  | $                                     | 0.22       |   |                                       | $ | 0.19                                 |  | $ | 0.65                                 |   |  | $ | 0.59      
|                                    |  |                                       |            |   |                                       |   |                                      |  |   |                                      |   |  |   |           

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, 2006 was approximately $6.9 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 make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gains. We declared dividends of
$0.17 per share (unit) paid on October 11, 2006, which we funded out of working capital.

Investing Activities. We
substantially completed renovations at three of our six initial hotels last year and have commenced renovations at the Crowne Plaza Jacksonville Hotel. During the nine months ended September 30, 2006, approximately $4.4 million was spent on
renovations and capital improvements. Of that amount, approximately $1.2 million was funded from our capital improvement reserve.



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On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg for $4.75 million. We took back
three promissory notes totaling $4.33 million from the purchaser and received the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with interest-only
payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007 at the election of the purchaser. The third note in the amount of $0.4 million with interest-only
payments due monthly at a rate of 8.0% will mature on August 31, 2007. We have committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due monthly for the
first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes are secured by a security interest in the hotel and by personal guarantees of affiliates
of the purchaser. The sale yielded cash proceeds of approximately $0.2 million.

On September 20, 2006, we purchased the 186-room
Louisville Ramada Riverfront Hotel in Jeffersonville, Indiana for approximately $7.7 million including transaction costs. We structured the purchase to meet the requirements of a Sec. 1031 like-kind exchange, enabling us to defer tax on all capital
gains on the sale in August of the Williamsburg property. To facilitate the closing of the acquisition, we accessed approximately $7.5 million from its line of credit, and approximately $0.2 million in cash proceeds from the sale of the Williamsburg
property.

These activities represent our net cash flow used in investing activities for the nine months ended September 30, 2006 of
approximately $10.7 million.

Financing Activities. For the nine months ended September 30, 2006, net cash provided by
financing activities was approximately $5.9 million. During the course of the year, we borrowed approximately $12.7 million to fund the purchase of the Louisville Ramada Riverfront Hotel in Jeffersonville, Indiana, the costs of renovations at the
Crowne Plaza Jacksonville Hotel that have not yet been reimbursed from the capital improvement reserve, and additional working capital. We incurred costs of approximately $0.6 million associated with the refinancing of our 4-year revolving credit
facility and made principal payments of approximately $0.8 million as required under various mortgage loan agreements. We also used approximately $5.4 million to make distributions to our unitholders and dividends to holders of our common stock.

Liquidity and Capital Resources

As of
September 30, 2006, we had cash and cash equivalents of approximately $5.8 million, of which $3.2 million was in restricted reserve accounts and real estate tax escrows. Coincident with the purchase of the Crowne Plaza Jacksonville Hotel, we
placed $3.0 million into a capital improvement reserve with Mercantile Safe Deposit and Trust Company, the mortgagors trustee. During the nine months ended September 30, 2006, approximately $1.2 million had been expended from the reserve.
On May 9, 2006, we replaced our existing $23.0 million secured line of credit with a revolving credit facility for up to $60.0 million that we expect to be available to finance future acquisitions as well as working capital. For a discussion of
the new line of credit, please see Note 5, Credit Facility, to the Companys consolidated financial statements provided in this report.

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



| |  |  | The issuance by the 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.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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

Capital Expenditures

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 that capital expenditures other than costs that we incur to make capital improvements required by our franchisors or capital expenditures relating to hotels we
acquire will be funded by our replacement reserve accounts. With respect to two of our hotels, the reserve accounts are escrowed with funds deposited monthly (5% of gross sales), and reserved for capital projects. The Hilton Savannah DeSoto and
Hilton Wilmington Riverside have these reserve accounts. Our intent for the capital reserve accounts at other hotels is to maintain overall capital expenditures at 4% of gross revenue.

On September 13, 2005, we entered into an agreement to purchase an interest in a condominium hotel property in Hollywood, Florida last operated as
the Ambassador Resort. The seller will renovate the hotel and complete a condominium conversion. We will retain MHI Hotels Services to manage the hotel on our behalf. Purchase of the interest in the property and costs related to pre-opening expenses
are expected to be incurred later this year and total approximately $3.8 million. Such costs will be funded by additional borrowings on the line of credit.

In addition, under the terms of the agreement, as amended on September 25, 2006, we may be required by the developer to purchase a maximum of 100 un-sold condominium units on or before August 1, 2007 at a
maximum price of $197,000 per unit subject to certain terms and conditions. In the event that the developer exercises his option, the purchase of additional units will be funded by additional borrowings on the line of credit. In conjunction with the
acquisition of the Louisville Ramada Riverfront Inn in Jeffersonville, Indiana, we intend to renovate and re-brand the hotel. Renovation costs are estimated at approximately $9.2 million and the property is expected to re-open in the third quarter
2007. Such costs will be funded by additional borrowings on the line of credit.

The franchise agreements at the Hilton Wilmington
Riverside Hotel and the Hilton Savannah DeSoto Hotel expire in 2008. In conjunction with the renewal of those agreements, we expect that we will be required to complete a property improvement plan (PIP). We estimate that the cost of the
required renovations to be approximately $8.0 million and will be expended beginning the second quarter 2007 through the second quarter 2008. We expect that the renovations will be funded initially by additional borrowings on the line of credit and
subsequently through refinancing the existing mortgages on the properties.

Contractual Obligations

The following table sets forth our contractual obligations as of September 30, 2006, and the effect such obligations are expected to have on our
liquidity and cash flow in future periods (in thousands).



|                                              |  |                        |        |                   |   |                    |  |                    |        |                      |   |        |  |   |    
|--------------------------------------------- |  | ---------------------- | ------ | ----------------- | - | ------------------ |  | ------------------ | ------ | -------------------- | - | ------ |  | - | ---
|                                              |  | Payments due by period
|Contractual Obligations                       |  | Total                  |        | Less ThanOne Year |   | One to Three Years |  | Three toFive Years |        | More Than Five Years
|Ground and building leases                    |  | $                      | 1,080  |                   | $ | 133                |  | $                  | 259    |                      | $ | 259    |  | $ | 429
|Mortgage loans                                |  |                        | 49,561 |                   |   | 3,323              |  |                    | 26,956 |                      |   | 19,282 |  |   |   
|Revolving credit facility, including interest |  |                        | 19,386 |                   |   | 876                |  |                    | 1,754  |                      |   | 16,756 |  |   |   
|                                              |  |                        |        |                   |   |                    |  |                    |        |                      |   |        |  |   |    
|                                              |  | $                      | 70,027 |                   | $ | 4,332              |  | $                  | 28,969 |                      | $ | 36,297 |  | $ | 429
|                                              |  |                        |        |                   |   |                    |  |                    |        |                      |   |        |  |   |    

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



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##### Table of Contents

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, North Carolina, Indiana, Maryland and Pennsylvania.

Critical Accounting Policies

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

Investment in Hotel Properties.Hotel properties are stated at cost, net of any impairment charges, and are depreciated using the straight-line method over an estimated useful life of 7-39 years for buildings
and 3-10 years for furniture and equipment. In accordance with generally accepted accounting principles, the majority interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and minority interests held by the
controlling holders of our accounting predecessor in hotels acquired from third parties are recorded at historical cost basis. Minority interests in those entities that comprise our accounting predecessor and the interests in hotels, other than
those held by the controlling members of our accounting predecessor, acquired from third parties are recorded at fair value 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 three months or nine months ended September 30, 2006 or 2005.

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



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##### Table of Contents

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

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

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, 2006. 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.

Forward Looking Statements

Information included and incorporated by reference in this Form 10-Q may contain forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or
achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans,
strategies and expectations, are generally identified by our use of words, such as intend, plan, may, should, will, project, estimate, anticipate,
believe, expect, continue, potential, opportunity, and similar expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and
financing plans are forward-looking statements. Factors, which could have a material adverse effect on our operations and future prospects, include, but are not limited to:



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



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



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



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



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



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



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



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

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

These risks and uncertainties, together with the information contained in our Form 10-K filed with the Securities and Exchange Commission on
March 23, 2006 under Risk Factors, should be considered in evaluating any forward-looking statement contained in this report or incorporated by reference herein. All forward-looking statements speak only as of the date of this
report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements
in this section. We undertake no obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

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



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##### Table of Contents

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 line of credit with BB&T 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, 2006, derivatives with a fair value of approximately $463,000 were included in
other 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, 2006, we had approximately $41.9 million of
fixed-rate debt and approximately, $16.2 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 7.95%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt,
but have no impact on interest incurred or cash flows. 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 the gap between the balance on the line of credit
and the $30.0 million notional amount of the interest rate swap purchased on August 8, 2006. Assuming that the amount outstanding under our line of credit remains at approximately $16.2 million, the balance at September 30, 2006, the
impact on our annual interest incurred and cash flows of a one percent change in 30-day LIBOR would be approximately $138,000.

As of
December 31, 2005, we had approximately $42.7 million of fixed-rate debt. The weighted average interest rate on the fixed-rate debt was 7.95%.

Item 4.Controls and Procedures

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

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



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##### Table of Contents

PART II

Item 1.Legal Proceedings

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

Item 1A.Risk Factors

There have been no material changes in our risk factors from those
disclosed in our annual report on Form 10-K for the year ended December 31, 2005.

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.



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##### Table of Contents

Item 6.Exhibits

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



|              |  |                                                                                                                                                                                       
|------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description of Exhibit                                                                                                                                                                
|31.1          |  | Certification of President and Chief Executive Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002
|              | 
|31.2          |  | Certification of Chief Financial Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002              
|              | 
|32.1          |  | Certification of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                       
|              | 
|32.2          |  | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                     

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 7, 2006 |  | By:                         |  | /s/ Andrew M. Sims                               
|                       |  |                             |  | Andrew M. Sims                                   
|                       |  |                             |  | Chief Executive Officer and Chairman of the Board



27