Overview

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

Our hotel portfolio currently consists of nine full-service, upper-upscale and mid-scale hotels with 2,138 rooms, which operate under well-known brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. We also own 25% indirect non-controlling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with The Carlyle Group and we have a leasehold interest in a resort condominium facility in Wrightsville Beach, North Carolina.

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

                                    Number
Property                           of Rooms   Location             Date of Acquisition
Operating properties
Hilton Philadelphia Airport             331   Philadelphia, PA     December 21, 2004
Holiday Inn Laurel West                 207   Laurel, MD           December 21, 2004
Holiday Inn Brownstone                  187   Raleigh, NC          December 21, 2004
Hilton Wilmington Riverside             272   Wilmington, NC       December 21, 2004
Hilton Savannah DeSoto                  246   Savannah, GA         December 21, 2004
Crowne Plaza Jacksonville               292   Jacksonville, FL     July 22, 2005
Sheraton Louisville Riverside           181   Jeffersonville, IN   September 20, 2006
Hampton Marina Hotel (1)                172   Hampton, VA          April 24, 2008
Properties under development
Crowne Plaza Tampa Westshore (2)        250   Tampa, FL            October 29, 2007

Total                                 2,138

(1) The property in Hampton, Virginia is operating as the Hampton Marina Inn while undergoing significant renovations and is expected to re-open as the Crowne Plaza Hampton Harborside in the fourth quarter 2008.

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

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

To qualify as a REIT, we cannot operate hotels. Therefore, our operating partnership leases our hotel properties to MHI Hospitality TRS, LLC, our TRS Lessee. 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.

Recent Portfolio Changes

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

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

On August 8, 2007, through our joint venture with Carlyle, we completed the acquisition of the Crowne Plaza Hollywood Beach Resort, a newly renovated 311-room hotel in Hollywood, Florida for $74.0 million, with Carlyle retaining a 75% equity position. A portion of the purchase was financed with a two-year $57.6 million non-recourse loan from Société Générale with two one-year extensions and which bore a rate of LIBOR plus 1.94%. On June 13, 2008, the joint venture purchased a $22.0 million junior participation in the mortgage loan and amended the promissory notes so that the first $35.6 million bears a rate of LIBOR plus 0.98%. The hotel is managed by MHI Hotels Services. We will also receive an asset management fee of 1.5% of gross revenues of the hotel in addition to our share of the operating profits and proceeds of sale pursuant to the joint venture agreement.

On October 29, 2007, we purchased a 250-room hotel in Tampa, Florida, formerly known as the Tampa Clarion Hotel for the aggregate purchase price of $13.5 million. We are in the process of making extensive renovations to the hotel and upon re-opening, the hotel will be re-branded as a Crowne Plaza, as is consistent with our repositioning strategy. Renovation costs are estimated at $25.0 million. The cost to acquire and renovate the hotel have been and will continue to be funded by additional borrowings on the credit facility.

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

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

Key Operating Metrics

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

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

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

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

Results of Operations

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



                                      Three months          Three months           Six months            Six months
                                          ended                 ended                 ended                 ended
                                      June 30, 2008         June 30, 2007         June 30, 2008         June 30, 2007
Actual Portfolio Metrics
Occupancy %                                     68.4 %                75.6 %                66.7 %                73.2 %
ADR                                  $        124.65       $        122.81       $        122.03       $        118.94
RevPAR                               $         85.31       $         92.83       $         81.43       $         87.12
Comparable Portfolio Metrics (1)
Occupancy %                                     73.9 %                75.6 %                69.3 %                73.2 %
ADR                                  $        125.24       $        122.81       $        122.23       $        118.94
RevPAR                               $         92.51       $         92.83       $         84.71       $         87.12

(1) The hotels included in the comparable portfolio metrics are those that were owned and operated both during 2007 and the six months ended June 30, 2008. They do not include results for the Sheraton Louisville Riverside which re-opened May 1, 2008, the Hampton Marina Hotel which was acquired on April 24, 2008, the

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

Revenue. Total revenue for the three months ended June 30, 2008 was approximately $20.5 million, an increase of approximately $1.1 million or 5.6% from total revenue of approximately $19.4 million for the three months ended June 30, 2007. The entire increase was attributable to operations at the Sheraton Louisville Riverside, which re-opened May 1, 2008 and the Hampton Marina Hotel, which was acquired April 24, 2008. We expect these properties to contribute significantly to growth in room revenue over the next year as the Sheraton Louisville Riverside becomes established in its market and as we reposition our hotel in Hampton, Virginia by branding it as a Crowne Plaza, which we expect will be complete in the first quarter 2009. While we expect to see overall increases in revenue due to contributions from newly-opened and newly-renovated properties, we expect revenues in the remainder of our hotel portfolio to be negatively impacted by the weaker economy, higher travel costs and decreased consumer spending.

For the three months ended June 30, 2007, the six properties which we owned throughout 2007 and the six months ended June 30, 2008 experienced a 0.5% decrease in room revenue despite a 2.0% increase in ADR, which was offset by a 2.3% decrease in occupancy. Most of the decrease in room revenue is attributable to renovations in progress at our Savannah, Georgia hotel, which impacted occupancy during the quarter. We expect improvements in room revenue at this property once renovations are completed in the first quarter 2009 as well as continued improvement at our hotel in Wilmington, North Carolina, which was completed this quarter.

Food and beverage revenues remained consistent at approximately $5.4 million for the three months ended June 30, 2008 compared to food and beverage revenues for the three months ended June 30, 2007. Contributions to food and beverage revenues from the Sheraton Louisville Riverside and the Hampton Marina Hotel were offset by decreases at the Hilton Savannah DeSoto, which is undergoing renovation, and the Hilton Wilmington Riverside, which has ceased operating its own restaurant and entered into a lease with a franchisee of Ruth's Chris restaurants.

Revenue from other operating departments for the three months ended June 30, 2008 increased approximately $0.1 million or 16.0% to approximately $1.1 million compared to other operating revenue of approximately $1.0 million for the three months ended June 30, 2007.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees, were approximately $15.2 million, an increase of approximately $1.3 million or 9.50% for the three months ended June 30, 2008 compared to approximately $13.9 million for the three months ended June 30, 2007. If not for the re-opening of the Sheraton Louisville Riverside and the acquisition of the Hampton Marina Hotel, hotel operating expenses would have decreased approximately $0.5 million. While we expect the overall level of hotel operating expenses to increase as the newly-opened Sheraton Louisville Riverside becomes established in its market and as the Hampton Marina Hotel is renovated and re-branded as a Crowne Plaza, we expect that such increases will be tempered by cost-cutting initiatives at our other properties in response to weaker consumer demand due to higher travel costs and the weaker economy.

Rooms expense for the three months ended June 30, 2008 increased to approximately $3.6 million, an increase of approximately $0.3 million or 9.8% for the three months ended June 30, 2008 compared to approximately $3.3 million for the three months ended June 30, 2007. Rooms expense from the Sheraton Louisville Riverside and the Hampton Marina Hotel accounted for the entire increase.

Food and beverage expenses for the three months ended June 30, 2008 remained constant at approximately $3.7 million compared to food and beverage expenses for the three months ended June 30, 2007, consistent with the same level of food and beverage revenue for the respective periods.

Indirect expenses at our properties for the three months ended June 30, 2008 increased approximately $1.0 million or 15.2% to approximately $7.6 million compared to indirect expenses of approximately $6.6 million for the three months ended June 30, 2007. Indirect expenses related to the Sheraton Louisville Riverside and the Hampton Marina Hotel, including approximately $0.3 million of start-up costs at the Sheraton Louisville Riverside, account for the increase in indirect expenses.

Depreciation and Amortization. Depreciation and amortization expense for the three months ended June 30, 2008 increased approximately $0.4 million or 29.7% to approximately $1.6 million compared to depreciation and amortization expense of approximately $1.2 million for the three months ended June 30, 2007. The increase in depreciation and amortization was attributable to the renovations placed in service at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside, as well as the acquisition of the Hampton Marina Hotel.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended June 30, 2008 decreased approximately $0.2 million or 19.6% to approximately $0.7 million compared to corporate general and administrative expense for the three months ended June 30, 2007 totaling approximately $0.9 million. One-time costs for legal fees in the prior year period associated with structuring the program and operating agreements that allow us to jointly acquire, develop and operate hotels assets and hotel portfolios with Carlyle contributed to much of the decrease.

Interest Expense. Interest expense for the three months ended June 30, 2008 increased approximately $0.7 million or 67.3% to approximately $1.7 million compared to interest expense for the three months ended June 30, 2007, primarily due to increased borrowings on the credit facility used to fund the renovations at the Hilton Wilmington Riverside. Additionally, we are realizing interest expense on the borrowings associated with the Sheraton Louisville Riverside subsequent to its re-opening and completion of its renovations, as well as borrowings associated with the purchase of the Hampton Marina Hotel. Lastly, we incurred an interest penalty of approximately $0.1 million associated with pre-payment of the indebtedness on the Hampton Marina Hotel when it was refinanced with a new $9.0 million mortgage from TowneBank.

Impairment of Note Receivable. Impairment of note receivable represents a $0.2 million valuation allowance against the $0.4 million promissory note we received upon the sale of the Holiday Inn Downtown Williamsburg in August 2006. No interest payments have been made since October 2007 and the debtor has recently entered into default on the first and second trusts on the property. The promissory note is secured by the property as well as personal guarantees by affiliates of the debtor. A charge for impairment is being taken in anticipation that a negotiated settlement for less than the full value of the note is more likely to occur than collection of the full face value of the note.

Equity in Joint Venture. Equity in joint venture for the three months ended June 30, 2008 represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort. During the quarter, the joint venture was able to restructure the mortgage on the property by purchasing a $22.0 million junior participation at a price of $19.0 million resulting in a $3.0 million gain on extinguishment of debt to the joint venture. For the three months ended June 30, 2008, the hotel reported occupancy of 57.0%, ADR of $142.14 and RevPAR of $81.06.

Income Taxes. The income tax provision for the three months ended June 30, 2008 decreased to approximately $0.1 million. The income tax benefit is primarily derived from the operations of our TRS lessee. The net operating income of our TRS lessee for the three months ended June 30, 2008 was less than the net operating income attributable to continuing operations for the three months ended June 30, 2007.

Net Income. The net income for the three months ended June 30, 2008 decreased approximately $0.1 million to approximately $1.3 million from net income of approximately $1.4 million for the three months ended June 30, 2007 as a result of the operating results discussed above.

Comparison of the Six Months Ended June 30, 2008 to the Six Months Ended June 30, 2007

Revenue. Total revenue for the six months ended June 30, 2008 was approximately $36.0 million, a decrease of approximately $0.3 million or 0.9% from the six months ended June 30, 2007. If not for revenue from the Sheraton Louisville Riverside, which re-opened May 1, 2008, and the Hampton Marina Hotel, which was acquired April 24, 2008, total revenue would have decreased approximately $1.5 million.

The six properties which we owned throughout 2007 and the six months ended June 30, 2008 experienced a 2.4% decrease in room revenue despite a 2.8% increase in ADR, which was offset by a 5.4% decrease in occupancy. Most of the decrease in room revenue is attributable to renovations in progress at our Wilmington, North Carolina and Savannah, Georgia properties, which impacted occupancy during the quarter. We have seen improvements in room revenue following the completion of renovations at the Hilton Wilmington Riverside and expect that once renovations at the Hilton Savannah DeSoto are complete in the first quarter 2009, that we will see continued improvements at both properties.

The largest decrease in revenue was from food and beverage revenues, which, for the six months ended June 30, 2008 declined to approximately $9.3 million, a decrease of approximately $0.9 million or 9.0% compared to food and beverage revenues for the six months ended June 30, 2007. While room sales from group business has remained strong at properties not undergoing renovation, there has been less demand for banqueting services resulting in a decrease in food and beverage revenue. Additionally, we realized lower food and beverage revenue at the Hilton Wilmington Riverside as one of our restaurants was undergoing renovation to re-open in June 2008 under a lease agreement with a franchisee of Ruth's Chris restaurants.

Revenue from other operating departments for the six months ended June 30, 2008 increased approximately $0.2 million or 11.2% to approximately $2.1 million compared to other operating revenue for the six months ended June 30, 2007.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees, were approximately $27.8 million, an increase of approximately $1.1 million or 4.0% for the six months ended June 30, 2008 compared to approximately $26.7 million for the six months ended June 30, 2007. If not for the re-opening of the Sheraton Louisville Riverside and the acquisition of the Hampton Marina Hotel, hotel operating expenses would have decreased approximately $0.5 million.

Rooms expense for the six months ended June 30, 2008 increased to approximately $6.7 million, an increase of approximately $0.4 million or 6.8% for the six months ended June 30, 2008 compared to approximately $6.3 million for the six months ended June 30, 2007. Rooms expense from the Sheraton Louisville Riverside and the Hampton Marina Hotel, as well as additional charges for three months of outside laundry services at our Philadelphia property necessitated by the breakdown of laundry equipment in mid-January, contributed to the increase in rooms expense.

Food and beverage expenses for the six months ended June 30, 2008 decreased approximately $0.3 million to approximately $6.7 million compared to food and beverage expenses of approximately $7.0 million for the six months ended June 30, 2007. A significant decrease in sales of food and beverage through lower orders of banqueting services at our hotels was partially offset by higher food costs in the first quarter.

Indirect expenses at our properties for the six months ended June 30, 2008 increased approximately $1.0 million or 7.3% to approximately $13.9 million compared to indirect expenses of approximately $12.9 million for the six months ended June 30, 2007. Indirect expenses related to the Sheraton Louisville Riverside and the Hampton Marina Hotel, including approximately $0.3 million of start-up costs at the Sheraton Louisville Riverside, account for the increase in indirect expenses.

Depreciation and Amortization. Depreciation and amortization expense for the six months ended June 30, 2008 increased approximately $0.5 million or 21.6% to approximately $3.0 million compared to depreciation and amortization expense of approximately $2.5 million for the six months ended June 30, 2007. The increase in depreciation and amortization was attributable to the renovations placed in service at the Hilton Wilmington Riverside and the Sheraton Louisville Riverside as well as the acquisition of the Hampton Marina Hotel.

Corporate General and Administrative. Corporate general and administrative expenses for the six months ended June 30, 2008 decreased approximately $0.1 million or 5.1% to approximately $1.7 million compared to corporate general and administrative expense for the six months ended June 30, 2007 totaling approximately $1.8 million. One-time costs in the prior period associated with structuring the program and operating agreements that allow us to jointly acquire, develop and operate hotels assets and hotel portfolios with Carlyle contributed to the decrease.

Interest Expense. Interest expense for the six months ended June 30, 2008 increased approximately $0.8 million or 39.0% to approximately $2.9 million compared to interest expense for the six months ended June 30, 2007, primarily due to increased borrowings on the credit facility used to fund the renovations at the Hilton Wilmington Riverside. Additionally, we are realizing interest expense on the borrowings associated with the Sheraton Louisville Riverside subsequent to its re-opening and completion of its renovations as well as borrowings associated with the purchase of the Hampton Marina Hotel. Lastly, we incurred an interest penalty of approximately $0.1 million associated with pre-payment of the indebtedness on the Hampton Marina Hotel when it was refinanced with a new $9.0 million mortgage from TowneBank.

Impairment of Note Receivable. Impairment of note receivable represents a $0.2 million valuation allowance against the $0.4 million promissory note we received upon sale of the Holiday Inn Downtown Williamsburg in August 2006. No interest payments have been made since October 2007 and the debtor has recently entered into default on the first and second trusts on the property. The promissory note is secured by the property as well as personal guarantees by affiliates of the debtor. A charge for impairment is being taken in anticipation that a negotiated settlement for less than the full value of the note is more likely to occur than collection of the full face value of the note.

Equity in Joint Venture. Equity in joint venture for the six months ended June 30, 2008 represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort. During the six months ended June 30, 2008, the joint venture was able to restructure the mortgage on the property by purchasing a $22.0 million junior participation at a price of $19.0 million resulting in a $3.0 million gain on extinguishment of debt to the joint venture. For the six months ended June 30, 2008, the hotel reported occupancy of 61.0%, ADR of $172.63 and RevPAR of $105.39.

Income Taxes. The effect of income taxes swung from an income tax provision of approximately $0.4 million for the six months ended June 30, 2007 to an income tax benefit of approximately $0.4 million for the six months ended June 30, 2008. The income tax benefit or provision is primarily derived from the operations of our TRS lessee. Our TRS lessee experienced a taxable loss for the six months ended June 30, 2008 in contrast to generating taxable income for the six months ended June 30, 2007.

Net Income. The net income for the six months ended June 30, 2008 decreased approximately $1.2 million or 57.9% to approximately $0.9 million from net income of approximately $2.0 million for the six months ended June 30, 2007 as a result of the operating results discussed above.

Funds From Operations

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