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 and sold 6,000,000 shares of common stock, resulting in net proceeds (after deducting underwriting discounts and offering expenses) of approximately $54.8 million. In conjunction with our initial public offering, we sold an additional 700,000 shares of common stock as a result of the exercise of the underwriters' over-allotment option in January 2005, resulting in additional proceeds of approximately $6.5 million.

Concurrent with the completion of the initial public offering, we acquired six hotel properties. Since the initial public offering, we have engaged in the following acquisitions and dispositions:

• On July 22, 2005, we acquired the Crowne Plaza Jacksonville (formerly, the Hilton Jacksonville Riverfront).

• On August 10, 2006, we sold the Holiday Inn Downtown Williamsburg.

• On September 20, 2006, we acquired the Louisville Ramada Riverfront Inn, which is under renovation and which we anticipate will re-open in April 2008 as the Sheraton Riverside Louisville.

• On August 8, 2007, through our joint venture with Carlyle, we acquired a 25% indirect non-controlling interest in the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida.

• On October 29, 2007, we acquired a 250-room hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel, which is under renovation and which we anticipate will re-open in the first quarter 2009 as the Crowne Plaza Tampa Westshore.

Our hotel portfolio currently consists of eight full-service, upper upscale and mid-scale hotels. These hotels are 100% owned by subsidiaries of our operating partnership. We also own a 25% indirect non-controlling interest in the Crowne Plaza Hollywood Beach Resort and we have a leasehold interest in a resort condominium facility in Wrightsville Beach, North Carolina. As of December 31, 2007, we owned the following eight hotel properties:

                                   Number of
Property                             Rooms     Location             Date of Acquisition
Operating Properties
Hilton Philadelphia Airport              331   Philadelphia, PA     December 21, 2004
Holiday Inn Laurel West                  207   Laurel, MD           December 21, 2004
Holiday Inn Brownstone                   187   Raleigh, NC          December 21, 2004
Hilton Wilmington Riverside              272   Wilmington, NC       December 21, 2004
Hilton Savannah DeSoto                   246   Savannah, GA         December 21, 2004
Crowne Plaza Jacksonville                292   Jacksonville, FL     July 22, 2005

Subtotal                               1,535
Properties Under Development
Sheraton Louisville Riverside(1)         186   Jeffersonville, IN   September 20, 2006
Crowne Plaza Tampa Westshore(2)          250   Tampa, FL            October 29, 2007

Total                                  1,971

(1) The property previously operated as the Louisville Ramada Riverfront Inn is currently undergoing extensive renovations and is expected to re-open in April 2008 as the Sheraton Louisville Riverside.

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 64.4% interest in our Operating Partnership, with the remaining interest being held by limited partners who were contributors of our original hotel properties and related assets.

To qualify as a REIT, we cannot operate hotels. Therefore, our operating partnership leases our hotel properties to 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.

Key Operating Metrics

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

Results of Operations

Comparison of Year Ended December 31, 2007 to Year Ended December 31, 2006

The following table illustrates the key operating metrics for the years ended December 31, 2007 and 2006 for the six operational properties that are in our current portfolio. Accordingly, it does not reflect the performance of the Holiday Inn Downtown Williamsburg, the property previously operated as the Louisville Ramada Riverfront Inn or the property previously operated as the Tampa Clarion Hotel.

                                          Year Ended December 31,
                                            2007             2006
                 Current Portfolio(1)
                 Occupancy %                    69.8 %          69.7 %
                 ADR                    $     118.86       $  112.22
                 RevPAR                 $      82.97       $   78.26

(1) The statistics presented for the current portfolio reflect the full-year metrics for all of the six operational hotels in our portfolio at the end of 2007.

Revenue. Total revenue for the year ended December 31, 2007 was approximately $69.8 million, an increase of approximately $2.6 million or 3.8% from total revenue for the year ended December 31, 2006 of approximately $67.2 million. Strong growth in room revenues of approximately 6.0% was offset by the loss of non-recurring consulting fees of approximately $0.7 million from the developer of the Crowne Plaza Hollywood Beach Resort in Hollywood, Florida.

Room revenues at our properties for the year ended December 31, 2007 increased approximately $2.6 million or 6.0% to approximately $46.5 million compared to room revenues for the year ended December 31, 2006 of approximately $43.9 million. A 6.0% increase in RevPAR was achieved through a combined increase in occupancy of 0.1% and average ADR growth of 5.9%. We continue to see increases in ADR at our Philadelphia property due to a better mix of business and a strong market. Our property in Laurel, Maryland contributed to the increase in ADR as we continue to see results from our efforts to reposition the property. Occupancy increases at our properties in Savannah, Georgia and Jacksonville, Florida were offset by occupancy decreases at our property in Wilmington, North Carolina that has been undergoing significant renovations which should be completed by April 2008. We expect that anticipated increases in occupancy in 2008 at our property in Wilmington, North Carolina will be offset by decreases in occupancy at our property in Savannah, Georgia where significant renovations have just begun and are not expected to be complete until December 2008.

Food and beverage revenues at our properties for the year ended December 31, 2007 increased approximately $0.4 million or 2.1% to approximately $19.5 million compared to food and beverage revenues for the year ended December 31, 2006 of approximately $19.1 million. With the exception of our Savannah, Georgia and Philadelphia properties where we saw a significant increase in demand for banqueting services, the remainder of our properties experienced weaker demand for such services. Overall, while room sales from group business have remained strong, the demand for banqueting services from those groups has not been as strong.

Other operating revenues for the year ended December 31, 2007 decreased approximately $0.5 million or 11.4% to approximately $3.7 million compared to other operating revenues for the year ended December 31, 2006 of approximately $4.2 million. In the last half of 2006, we realized approximately $0.7 million in non-recurring consulting fees from the developer of the Hollywood, Florida property.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, indirect expenses, and management fees, increased approximately $1.7 million or 3.3% for the year ended December 31, 2007 to approximately $51.9 million compared to hotel operating expenses for the year ended December 31, 2006 of approximately $50.2 million.

Rooms expense at our properties for the year ended December 31, 2007 increased approximately $0.2 million or 1.3% to approximately $12.3 million compared to rooms expense of approximately $12.1 million for the year ended December 31, 2006. As a percent of room revenues, rooms expense fell from 27.6% to 26.4%. The decrease was due to one-time costs realized in the year ended December 31, 2006 to replace room amenities at our Hilton brand properties.

Food and beverage expenses at our properties for the year ended December 31, 2007 increased approximately $0.7 million or 5.0% to approximately $13.7 million compared to food and beverage expense of approximately $13.0 million for the year ended December 31, 2006. Higher food costs and increased costs related to the renovation of the kitchen at the Wilmington, North Carolina property contributed to the increase in food and beverage expense. Indirect expenses at our properties for the year ended December 31, 2007 increased approximately $0.9 million or 3.5% to approximately $25.1 million compared to indirect expenses of approximately $24.2 million for the year ended December 31, 2006.

Depreciation and Amortization.Depreciation and amortization for the year ended December 31, 2007 increased approximately $0.1 million or 2.7% to approximately $5.0 million compared to depreciation and amortization expense of approximately $4.9 million for the year ended December 31, 2006.

Corporate General and Administrative. Corporate general and administrative expenses for the year ended December 31, 2007 increased approximately $0.5 million or 21.1% to approximately $3.1 million compared to corporate general and administrative expenses of approximately $2.6 million for the year ended December 31, 2006. A substantial portion of the increase is attributable to the bonuses granted pursuant to the cash bonus plan for principal executive officers established in the first quarter 2007 by the Nominating, Corporate Governance

and Compensation Committee of the Board of Directors. We also incurred additional legal fees in structuring the program and operating agreements that will allow us to jointly acquire, develop and operate hotel assets and, perhaps, hotel portfolios with Carlyle.

Net Operating Income.Operating income for the year ended December 31, 2007 increased approximately $0.2 million or 2.4% to approximately $9.7 million compared to approximately $9.5 million of operating income for the year ended December 31, 2006 as a result of the operating results discussed above.

Interest Expense. Interest expense for the year ended December 31, 2007 decreased approximately $0.05 million or 1.2% to approximately $4.2 million (net of capitalized interest of approximately $1.0 million) compared to approximately $4.3 million of interest expense (net of capitalized interest of approximately $0.2 million) for the year ended December 31, 2006. Lower interest expense related to borrowings on the credit facility for working capital purposes was partially offset by higher interest expense on the mortgage on the Wilmington Hilton Riverside. Interest expense in future periods should increase due to increased borrowings to fund our investment in the joint venture with Carlyle that purchased the Crowne Plaza Hollywood Beach Resort as well as the renovations to the Hilton Savannah DeSoto. Interest expense will also increase once the Sheraton Louisville Riverside North in Jeffersonville, Indiana opens and the interest on the borrowings related to that property are no longer capitalized.

Equity Loss in Joint Venture. Equity loss in the joint venture for the year ended December 31, 2007 represents our share of the start-up costs for the Crowne Plaza Hollywood Beach Resort as well as the initial operating losses incurred during the first three months of operation. During the first few months of operation ending December 31, 2007, the hotel reported occupancy of 32.1%, ADR of $144.94 and RevPAR of $46.58.

Income Taxes. We experienced an income tax benefit for the year ended December 31, 2007 of approximately $0.2 million compared to an income tax provision of approximately $0.3 million for the year ended December 31,2006. The income tax benefit in the current year was largely due to our share of start-up expenses and initial operating losses from our joint venture with Carlyle related to the opening of the Crowne Plaza Hollywood Beach Resort.

Net Income.Net income for the year ended December 31, 2007 decreased approximately $0.7 million or 22.6% to approximately $2.5 million compared to approximately $3.2 million for the year ended December 31, 2006 as a result of the operating results discussed above.

Sources and Uses of Cash

Operating Activities. Our principal source of cash to meet our operating requirements, including distributions to unit holders and stockholders as well as repayments of indebtedness, is the operations of our hotels. Cash flow provided by operating activities for the year ended December 31, 2007 was approximately $12.8 million. We expect that the net cash provided by operations will be adequate to fund the Company's operating requirements, debt service and the payment of dividends in accordance 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 gain. We declared dividends of $0.17 per share (unit) paid on January 11, 2007, April 11, 2007, July 11, 2007, and October 11, 2007, which we funded out of working capital.

Investing Activities. Approximately $18.6 million was spent during the year ended December 31, 2007 on renovations and capital improvements. Over $15.7 million was spent on renovations at Wilmington Hilton Riverside and our property in Jeffersonville, Indiana. We expect that renovations at both properties will be completed in April 2008. At the end of 2007, renovation at the Savannah Hilton DeSoto began, as well.

On February 6, 2007, we received payment of $2.63 million for the first of three promissory notes originating from the sale on August 10, 2006 of the Holiday Inn Downtown Williamsburg. On March 14, 2007, we received $1.4 million representing payment of the second of three promissory notes originating from the same sale.

On August 8, 2007, we contributed approximately $6.6 million to a joint venture which acquired the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida retaining a 25% equity position. A portion of the aggregate purchase price of $74.0 million was financed with a two-year $57.6 million non-recourse loan from Sociιtι Gιnιrale. The contribution to the joint venture was funded through draws on our credit facility.

On October 29, 2007, the Company completed the purchase of a 250-room hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel for approximately $13.8 million, including transaction costs. To facilitate the closing of the acquisition, we drew approximately $13.8 million on our credit facility.

These activities represent our cash flow used in investing activities for the year ended December 31, 2007 of approximately $35.0 million.

Financing Activities. For the year ended December 31, 2007, net cash provided by financing activities was approximately $24.8 million. During the course of the year we refinanced the mortgages on the Wilmington Hilton Riverside and the Savannah Hilton DeSoto generating proceeds of approximately $13.9 million for the purpose of funding renovations at both properties pursuant to franchisor mandated capital improvement programs. We also borrowed approximately $19.2 million to fund continued renovations at our property in Jeffersonville, Indiana, our contribution to a joint venture with Carlyle for the purchase of the Crowne Plaza Hollywood Beach Resort in which we retain a 25% indirect non-controlling interest, as well as the purchase of the property formerly known as the Tampa Clarion Hotel in Tampa, Florida. We incurred costs of approximately $0.6 million associated with the extension of our revolving credit facility and made principal payments of approximately $0.5 million as required under various mortgage loan agreements. We also used approximately $7.2 million to make distributions to our unitholders and dividends to holders of our common stock.

Capital Expenditures

Recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment, as well as debt service, are our most significant short-term liquidity requirements. During the next 12 months, we expect capital expenditures will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. With respect to three of our hotels, the reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures. We deposit an amount equal to 4% of gross revenue for both the Hilton Savannah DeSoto and Hilton Wilmington Riverside and 4% of room revenues for the Crowne Plaza Jacksonville. Our intent for the capital expenditures at all hotels is to maintain overall capital expenditures at 4% of gross revenue.

On September 20, 2006, we purchased the Louisville Ramada Riverfront Inn in Jeffersonville, Indiana with the intention of renovating and re-branding the hotel. On February 23, 2007, we obtained a 15-year franchise license agreement with Starwood Hotels and Resorts to brand the property as a Sheraton hotel. Renovation costs are estimated at approximately $15.9 million and the property is expected to re-open in April 2008. Approximately $8.8 million had been expended as of December 31, 2007. All costs have been and will be funded by additional borrowings on our credit facility.

In February 2007, the franchise license for the Hilton Wilmington Riverside was renewed and extended to March 2018. To comply with the re-licensing agreement, we must complete a property improvement plan ("PIP"). We estimate the cost of the required renovations to total approximately $10.4 million and be completed in April 2008. Approximately $8.3 million had been expended as of December 31, 2007. The remaining costs will be funded by additional borrowings on our credit facility.

In July 2007, the franchise license for the Hilton Savannah DeSoto Hotel was renewed and extended to July 2018. To comply with the re-licensing agreement, we must complete a PIP, which we expect to be completed in February 2009 and total approximately $11.0 million. Approximately $2.0 million had been expended as of December 31, 2007. The renovations will be funded by additional draws of $9.0 million on the mortgage that was refinanced in August 2007.

On October 29, 2007, we purchased the property formerly known as the Tampa Clarion Hotel in Tampa, Florida with the intention of renovating and re-branding the hotel. On October 31, 2007, we obtained a 10-year franchise agreement with InterContinental Hotels Group to brand the property as a Crowne Plaza hotel. Renovation costs are estimated at approximately $20.0 million, of which approximately $1.0 million had been expended as of December 31, 2007. The renovations will be funded by additional borrowings on our credit facility.

On January 23, 2008, we entered into a definitive agreement to purchase the Hampton Marina Hotel in Hampton, Virginia for the aggregate purchase price of $7.85 million. On February 27, 2008, we obtained a 10-year franchise agreement with InterContinental Hotels Group to brand the property as a Crowne Plaza hotel. In conjunction with the license agreement, we expect that we will be required to complete a PIP. However, the scope of the required renovations has not been determined. We estimate the cost of renovation to range between $3.0 million and $6.0 million and anticipate that the costs will be expended between the third quarter 2008 and the first quarter 2009. We intend to fund the acquisition and the renovations through a first mortgage on the hotel and additional borrowings on our credit facility.

Liquidity and Capital Resources

As of December 31, 2007, we had cash and cash equivalents of approximately $5.7 million, of which $1.7 million was in restricted reserve accounts and real estate tax escrows. As of December 31, 2007, our revolving credit facility, under which we may borrow up to $60.0 million, had an outstanding balance of approximately $34.4 million. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment as well as debt service.

We estimate that in order to complete all the capital projects to which we are committed, we will require capital ranging from approximately $48.0 million to $52.0 million. Most of the capital will be required before the end of the fourth quarter 2008 and should not exceed $6.0 million in the first quarter 2009. We expect that $9.0 million will be obtained through additional draws on the mortgage on the Hilton Savannah DeSoto. We also expect to acquire the property in Hampton, Virginia subject to a first mortgage ranging between $3.5 and $6.0 million. We expect that the remaining capital will be funded by additional borrowings on our credit facility. The facility contains an uncommitted accordion facility that we intend to exercise and expect to expand the commitment from $60.0 million to $75.0 million. We believe the expanded facility will provide sufficient capital to accommodate our needs for committed capital projects as well as working capital.

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

• The issuance by 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 through the refinance of an existing or new indebtedness on our 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 or 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 contribution.

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

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

• The issuance by the 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 or development land to strategic joint ventures to be formed with unrelated investors, which would have the net effect of generating additional capital through such sale or contributions.

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

Mortgage Debt

We have $55.0 million of outstanding mortgage debt. The following table sets
forth the mortgage debt outstanding at December 31, 2007:



                                     Principal
                                   Balance as of        Prepayment       Interest       Maturity     Amortization
Property                         December 31, 2007      Penalties        Rate(1)          Date        Provisions
                                  (In thousands)
Crowne Plaza Jacksonville       $            18,000             (2 )         8.00 %     Jul 2010             None
Hilton Wilmington Riverside                  23,000             (3 )         6.21 %     Mar 2018         25 years (4)
Hilton Savannah DeSoto                       14,000             (5 )         6.06 %     Jul 2018         25 years (6)

Total                           $            55,000

(1) Fixed rate.

(2) The note may not be prepaid prior to July 2009. A prepayment may be made following that date without penalty.

(3) The note may not be prepaid prior to March 2014. Prepayment can be made with penalty thereafter until 90 days before maturity.

(4) The note provides for payments of interest only until March 2009 after which payments of principal and interest under a 25-year amortization schedule are due until the note matures in March 2018.

(5) The note may not be prepaid prior to July 2014. Prepayment can be made with penalty thereafter until 90 days before maturity.

. . .