Overview

We are a self-managed and self-administered REIT incorporated in Maryland in August 2004 to pursue opportunities primarily in the full-service upper-upscale and upscale segments of the hotel industry located in primary and secondary markets in the Mid-Atlantic and Southern United States. We commenced operations in December 2004 when we completed our initial public offering (the "IPO") and thereafter consummated the acquisition of the initial properties.

Our hotel portfolio currently consists of nine full-service, upper-upscale and upscale hotels and one midscale hotel, collectively with 2,113 rooms which operate under well-known brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. These hotels are 100% owned by subsidiaries of our Operating Partnership. We also own a 25.0% indirect noncontrolling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with Carlyle. In total, our hotel portfolio contains 2,424 rooms. As of June 30, 2012, we owned the following hotel properties:

                                          Number
Property                                 of Rooms            Location         Date of Acquisition
Wholly-owned
Crowne Plaza Hampton Marina                    173      Hampton, VA           April 24, 2008
Crowne Plaza Jacksonville Riverfront           292      Jacksonville, FL      July 22, 2005
Crowne Plaza Tampa Westshore                   222      Tampa, FL             October 29, 2007
Doubletree by Hilton
Brownstone-University                          190      Raleigh, NC           December 21, 2004
Hilton Philadelphia Airport                    331      Philadelphia, PA      December 21, 2004
Hilton Savannah DeSoto                         246      Savannah, GA          December 21, 2004
Hilton Wilmington Riverside                    272      Wilmington, NC        December 21, 2004
Holiday Inn Laurel West                        207      Laurel, MD            December 21, 2004
Sheraton Louisville Riverside                  180      Jeffersonville, IN    September 20, 2006

                                             2,113

Joint Venture Property
Crowne Plaza Hollywood Beach Resort            311      Hollywood, FL         August 9, 2007

Total                                        2,424

We conduct substantially all our business through our Operating Partnership. We are the sole general partner of our Operating Partnership, and we own an approximate 77.0% 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 wholly-owned hotel properties to MHI Hospitality TRS, LLC (our "TRS Lessee"), which then engages a hotel management company to operate the hotels under a management contract. Our TRS Lessee has engaged MHI Hotels Services 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, 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 each of the
three months and six months ended June 30, 2012 and 2011 for the properties we
wholly-owned during each respective reporting period.



                                Three months ended            Three months ended            Six months ended            Six months ended
                                  June 30, 2012                 June 30, 2011                June 30, 2012               June 30, 2011
Occupancy %                                    76.4 %                        72.9 %                      71.2 %                      68.0 %
ADR                            $             120.88          $             115.46          $           115.70          $           111.89
RevPAR                         $              92.35          $              84.19          $            82.43          $            76.11

Comparison of the Three Months Ended June 30, 2012 to the Three Months Ended June 30, 2011

Revenue. Total revenue for the three months ended June 30, 2012 increased approximately $2.0 million or 8.6% to approximately $25.1 million compared to total revenue of approximately $23.1 million for the three months ended June 30, 2011. All our properties experienced increases in revenue except our Hampton, Virginia property.

Room revenue increased approximately $1.6 million or 9.9% to approximately $17.8 million for the three months ended June 30, 2012 compared to room revenue of approximately $16.2 million for the three months ended June 30, 2011. The increase in room revenue for the three months ended June 30, 2012 resulted from a 4.7% increase in ADR and a 4.8% increase in occupancy as compared to the same period in 2011. Room revenue increased at all our properties except our Hampton, Virginia property.

Food and beverage revenues increased approximately $0.4 million or 7.2% to approximately $6.2 million for the three months ended June 30, 2012 compared to food and beverage revenues of approximately $5.8 million for the three months ended June 30, 2011. A significant amount of the increase was attributable to the opening of the Mojito restaurant at our Tampa, Florida property. Increases in banqueting revenue at our properties in Jeffersonville, Indiana and Raleigh, North Carolina offset a small decrease in food and beverage revenue at our property in Philadelphia, Pennsylvania.

Revenue from other operating departments for the three months ended June 30, 2012 remained constant at approximately $1.2 million compared to revenue from other operating departments for the three months ended June 30, 2011.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses and management fees, were approximately $17.3 million, an increase of approximately $0.9 million or 5.5% for the three months ended June 30, 2012 compared to total hotel operating expenses of approximately $16.4 million for the three months ended June 30, 2011. The increase in hotel operating expense was mostly attributable to an increase in operating revenue.

Rooms expense for the three months ended June 30, 2012 increased approximately $0.2 million or 4.5% to approximately $4.5 million compared to rooms expense of approximately $4.3 million for the three months ended June 30, 2011. The increase was largely related to the increase in occupancy and revenue.

Food and beverage expenses for the three months ended June 30, 2012 increased approximately $0.3 million or 6.7% to approximately $4.0 million compared to food and beverage expenses of approximately $3.7 million for the three months ended June 30, 2011. Most of the increase in food and beverage expense was directly related to the increase in food and beverage revenues. An improvement in food and beverage margins from 35.7% to 36.0% offset the cost of higher volume.

Indirect expenses at our wholly-owned properties for the three months ended June 30, 2012 increased approximately $0.5 million or 5.9% to approximately $8.7 million compared to indirect expenses of approximately $8.2 million for the three months ended June 30, 2011. Management fees and franchise fees increased directly in proportion to the increase in revenue. Energy and utility expenses were lower due to lower energy prices. Repairs and maintenance, insurance, real and personal property taxes as well as general and administrative costs at the property level are also included in indirect expenses.

Depreciation and Amortization. Depreciation and amortization expense for the three months ended June 30, 2012 increased approximately $0.1 million or 2.1% to approximately $2.2 million compared to depreciation and amortization expense of approximately $2.1 million for the three months ended June 30, 2011.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended June 30, 2012 increased approximately $0.2 million or 13.5% to approximately $1.0 million compared to corporate general and administrative expense of approximately $0.8 million for the three months ended June 30, 2011 due mostly to higher legal fees.

Interest Expense. Interest expense for the three months ended June 30, 2012 increased approximately $1.6 million or 57.5% to approximately $4.3 million compared to interest expense of approximately $2.7 million for the three months ended June 30, 2011. Most of the increase was attributable to the premium paid to redeem approximately 11,514 shares of Preferred Stock in June 2012 of approximately $0.8 million as well as the write-off of unamortized issuance costs related to the redeemed shares of approximately $0.7 million.

Equity Income in Joint Venture. Equity income in joint venture for the three months ended June 30, 2012 represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort. For the three months ended June 30, 2012, our 25.0% share of the net loss of the hotel decreased approximately $0.1 million or 47.3% to approximately $0.1 million compared to a net loss of approximately $0.2 million for the three months ended June 30, 2011. For the three months ended June 30, 2012, the hotel reported occupancy of 80.5%, ADR of $133.47 and RevPAR of $107.45. This compares with results reported by the hotel for the three months ended June 30, 2011 of occupancy of 82.1%, ADR of $124.49 and RevPAR of $102.19.

Unrealized Loss on Warrant Derivative. The Company recognized an unrealized loss of approximately $1.5 million on the value of the warrant derivative issued in April 2011 to the purchasers of Preferred Stock. The loss was attributable to the increase in price of the underlying common stock.

Income Taxes. The income tax provision or benefit is primarily derived from the operations of our TRS Lessee. The Company's income tax expense increased approximately $0.2 million or 21.5% to approximately $1.0 million for the three months ended June 30, 2012 as compared to income tax expense of approximately $0.8 million for the three months ended June 30, 2011.

Net Loss Attributable to the Company. The net loss attributable to the Company for the three months ended June 30, 2012 increased approximately $1.5 million to approximately $1.7 million as compared to a net loss of approximately $0.2 million for the three months ended June 30, 2011 as a result of the operating results discussed above.

Comparison of the Six Months Ended June 30, 2012 to the Six Months Ended June 30, 2011

Revenue. Total revenue for the six months ended June 30, 2012 increased approximately $3.4 million or 8.3% to approximately $45.1 million compared to total revenue of approximately $41.7 million for the six months ended June 30, 2011. All our properties experienced increases in revenue except our Wilmington, North Carolina and Hampton, Virginia properties.

Room revenue increased approximately $2.6 million or 9.1% to approximately $31.7 million for the six months ended June 30, 2012 compared to room revenue of approximately $29.1 million for the six months ended June 30, 2011. The increase in room revenue for the six months ended June 30, 2012 resulted from a 4.7% increase in occupancy and a 3.4% increase in ADR as compared to the same period in 2011. Room revenue increased at all our properties except our Hampton, Virginia property.

Food and beverage revenues increased approximately $0.9 million or 8.1% to approximately $11.2 million for the six months ended June 30, 2012 compared to food and beverage revenues of approximately $10.3 million for the six months ended June 30, 2011. A significant amount of the increase was attributable to the opening of the Mojito restaurant at our Tampa, Florida property. Increases in banqueting revenue at our properties in Raleigh, North Carolina and Laurel, Maryland offset decreases in food and beverage revenue at our properties in Wilmington, North Carolina and Hampton, Virginia.

Revenue from other operating departments for the six months ended June 30, 2012 remained constant at approximately $2.3 million compared to revenue from other operating departments for the six months ended June 30, 2011.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses and management fees, were approximately $32.7 million, an increase of approximately $1.8 million or 5.8% for the six months ended June 30, 2012 compared to total hotel operating expenses of approximately $30.9 million for the six months ended June 30, 2011. The increase in hotel operating expense was mostly attributable to an increase in operating revenue.

Rooms expense for the six months ended June 30, 2012 increased approximately $0.4 million or 5.7% to approximately $8.4 million compared to rooms expense of approximately $8.0 million for the six months ended June 30, 2011. The increase was largely related to the increase in occupancy and revenue.

Food and beverage expenses for the six months ended June 30, 2012 increased approximately $0.6 million or 7.6% to approximately $7.4 million compared to food and beverage expenses of approximately $6.8 million for the six months ended June 30, 2011. Most of the increase in food and beverage expense was directly related to the increase in food and beverage revenues. An improvement in food and beverage margins from 33.8% to 34.2% offset the cost of higher volume.

Indirect expenses at our wholly-owned properties for the six months ended June 30, 2012 increased approximately $0.8 million or 5.4% to approximately $16.6 million compared to indirect expenses of approximately $15.8 million for the six months ended June 30, 2011. Management fees and franchise fees increased directly in proportion to the increase in revenue. Sales and marketing costs increased as vacant positions were filled and additional staff was hired in anticipation of improvement in group business. Energy and utility expenses moderated due to the mild winter as well as lower energy costs despite the increase in occupancy. Repairs and maintenance, insurance, real and personal property taxes as well as general and administrative costs at the property level are also included in indirect expenses.

Depreciation and Amortization. Depreciation and amortization expense for the six months ended June 30, 2012 increased approximately $0.1 million or 2.4% to approximately $4.4 million compared to depreciation and amortization expense of approximately $4.3 million for the six months ended June 30, 2011.

Corporate General and Administrative. Corporate general and administrative expenses for the six months ended June 30, 2012 increased approximately $0.3 million or 16.0% to approximately $2.1 million compared to corporate general and administrative expense of approximately $1.8 million for the six months ended June 30, 2011 due mostly to higher staffing costs and higher legal fees.

Interest Expense. Interest expense for the six months ended June 30, 2012 increased approximately $2.3 million or 42.7% to approximately $7.6 million compared to interest expense of approximately $5.3 million for the six months ended June 30, 2011. The increase was mostly attributable to the write-off of unamortized loan costs in conjunction with the extinguishment of the credit facility in March 2012 of approximately $0.5 million, the premium paid to redeem approximately 11,514 shares of Preferred Stock in June 2012 of approximately $0.8 million, the write-off of unamortized issuance costs related to the redeemed shares of approximately $0.7 million as well as comparably higher interest in the first quarter associated with the Preferred Stock issued in April 2011.

Equity Income in Joint Venture. Equity income in joint venture for the six months ended June 30, 2012 represents our 25.0% share of the net income of the Crowne Plaza Hollywood Beach Resort. For the six months ended June 30, 2012, our 25.0% share of the net income of the hotel increased approximately $0.1 million or 45.1% to approximately $0.2 million compared to our 25.0% share of net income from the hotel of approximately $0.1 million for the six months ended June 30, 2011. For the six months ended June 30, 2012, the hotel reported occupancy of 84.0%, ADR of $156.94 and RevPAR of $131.85. This compares with results reported by the hotel for the six months ended June 30, 2011 of occupancy of 85.2%, ADR of $139.28 and RevPAR of $118.64.

Unrealized Loss on Warrant Derivative. The Company recognized an unrealized loss of approximately $2.7 million for the six months ended June 30, 2012 compared to an unrealized loss of approximately $0.4 million for the six months ended June 30, 2011. The change in the value of the warrant derivative was mostly attributable to the increase in price of the underlying common stock.

Income Taxes. The income tax provision or benefit is primarily derived from the operations of our TRS Lessee. The Company's income tax expense increased approximately $0.3 million or 27.0% to approximately $1.1 million for the six months ended June 30, 2012 as compared to income tax expense of approximately $0.8 million for the six months ended June 30, 2011.

Net Loss Attributable to the Company. The net loss attributable to the Company for the six months ended June 30, 2012 increased approximately $2.7 million to approximately $3.9 million as compared to a net loss of approximately $1.2 million for the six months ended June 30, 2011 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 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 noncontrolling 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. Management believes 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 loss to FFO for each of the three months and six months ended June 30, 2012 and 2011 (unaudited):

                                   Three months  ended            Three months  ended            Six months  ended            Six months  ended
                                      June 30, 2012                  June 30, 2011                 June 30, 2012                June 30, 2011
Net loss                          $          (2,146,312 )        $            (243,501 )        $        (5,126,655 )        $        (1,579,971 )
Add depreciation and
amortization                                  2,195,591                      2,149,910                    4,375,554                    4,273,387
Add equity in depreciation
of joint venture                                182,930                        137,399                      320,742                      274,027
Subtract gain on disposal
of assets                                            -                          (6,055 )                         -                       (12,255 )

FFO                               $             232,209          $           2,037,753          $          (430,359 )        $         2,955,188

Weighted average shares
outstanding                                   9,999,786                      9,617,116                    9,991,445                    9,588,996
Weighted average units
outstanding                                   2,980,883                      3,324,109                    2,982,861                    3,339,190

Weighted average shares and
units                                        12,980,669                     12,941,225                   12,974,306                   12,928,186

FFO per share and unit            $                0.02          $                0.16          $             (0.03 )        $              0.23

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 six months ended June 30, 2012 was approximately $5.0 million. We expect that the net cash provided by operations will be adequate to fund our continuing operations, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends in accordance with federal income tax laws which require us to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gains.

Investing Activities. Approximately $2.0 million was spent during the six months ended June 30, 2012 on capital improvements and the replacement of furniture, fixtures and equipment.

Financing Activities. On March 5, 2012, we obtained a mortgage on the Hilton Philadelphia Airport for $30.0 million and used the proceeds to extinguish the credit facility and repay a portion of the outstanding indebtedness on the $10.0 million loan agreement with Essex Equity High Income Joint Investment Vehicle, LLC (the "Note Agreement" or "Bridge Financing").

On June 18, 2012, we obtained mortgage on the Crowne Plaza Tampa Westshore for $14.0 million and used the proceeds to repay the outstanding indebtedness on the Bridge Financing and to redeem approximately 11,514 shares of Preferred Stock.

Capital Expenditures

We anticipate that our need for recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be at or lower than historical norms for our properties and the industry. Historically, we have aimed to maintain overall capital expenditures at 4.0% of gross revenue. However, in the interest of preserving capital, we aim to restrict capital expenditures to the replacement of broken or damaged furniture and equipment and the acquisition of items mandated by our licensors that are necessary to maintain our brand affiliations. We anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment that are not related to a product improvement plan should total 3.00% to 3.50% of gross revenues during the next 12 to 24 months.

We expect capital expenditures for the replacement or refurbishment of furniture, fixtures and equipment at our properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors. Reserve accounts are escrowed accounts with funds deposited monthly and reserved for capital improvements or expenditures with respect to all of our hotels. We currently deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Crowne Plaza Hampton Marina and the Sheraton Louisville Riverside as well as 4.0% of room revenues for the Crowne Plaza Jacksonville Riverfront and the Hilton Philadelphia Airport on a monthly basis.

Liquidity and Capital Resources

As of June 30, 2012, we had cash and cash equivalents of approximately $9.3 million, of which approximately $2.3 million was in restricted reserve accounts and real estate tax and insurance escrows. 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, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and dividends on the Preferred Stock.

In June 2012, we obtained a $14.0 million mortgage with C1 Bank on the Crowne Plaza Tampa Westshore in Tampa, Florida. The proceeds of the loan were used to repay the outstanding indebtedness on the Bridge Financing as well as redeem approximately 45.0% of the outstanding shares of Preferred Stock.

In June 2012, we extended the maturity of the mortgage on the Crowne Plaza Hampton Marina until June 2013. At that time, we intend to obtain mortgage financing with a 5-year term. If we are unable to obtain such financing on favorable terms, we may be required to reduce the mortgage balance by an amount up to $1.0 million or may seek to secure an extension of the existing mortgage indebtedness.

In July 2012, we obtained a $14.3 million mortgage on the Crowne Plaza Jacksonville Riverfront. The maturity date is July 10, 2015, but may be extended for an additional year pursuant to certain terms and conditions. The mortgage . . .