Highland Hospitality (HIH) 10-Q 2005 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2005

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 001-31906

HIGHLAND HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

MARYLAND	57-1183293
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

8405 Greensboro Drive, Suite 500, McLean, Virginia 22102

Telephone Number (703) 336-4901

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).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

As of November 4, 2005, there were 51,591,005 shares of the registrant’s common stock issued and outstanding.

HIGHLAND HOSPITALITY CORPORATION

INDEX

	Page
PART I
Item 1. Financial Statements	3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3. Quantitative and Qualitative Disclosures About Market Risk	29
Item 4. Controls and Procedures	30
PART II
Item 1. Legal Proceedings	31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 3. Defaults Upon Senior Securities	31
Item 4. Submission of Matters to a Vote of Security Holders	31
Item 5. Other Information	31
Item 6. Exhibits	31

2

PART I

Item 1. Financial Statements

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

	September 30, 2005			December 31, 2004
	(unaudited)
ASSETS
Investment in hotel properties, net	$	705,023		$	578,715
Asset held for sale		3,000			3,000
Deposits on hotel property acquisitions		8,151			8,714
Cash and cash equivalents		205,515			75,481
Restricted cash		20,777			38,710
Accounts receivable, net of allowance for doubtful accounts of $137 and $133 at September 30, 2005 and December 31, 2004, respectively		14,316			7,010
Prepaid expenses and other assets		14,179			8,279
Deposits on loan applications		223			—
Deferred financing costs, net of accumulated amortization of $977 and $191 at September 30, 2005 and December 31, 2004, respectively		4,270			4,732
Total assets	$	975,454		$	724,641
LIABILITIES AND STOCKHOLDERS’ EQUITY
Long-term debt	$	416,987		$	342,854
Accounts payable and accrued expenses		20,932			17,140
Dividends/distributions payable		7,338			5,726
Other liabilities		2,811			3,122
Total liabilities		448,068			368,842
Minority interest in operating partnership		7,044			8,321
Commitments and contingencies (Note 10)
Preferred stock, $.01 par value; 100,000,000 shares authorized: Series A Cumulative Redeemable Preferred Stock; 3,000,000 shares issued and outstanding at September 30, 2005		72,360			—
Common stock, $.01 par value; 500,000,000 shares authorized; 51,674,699 shares and 40,002,011 shares issued at September 30, 2005 and December 31, 2004, respectively		516			400
Additional paid-in capital		478,699			366,856
Treasury stock, at cost; 83,694 shares and 71,242 shares at September 30, 2005 and December 31, 2004, respectively		(936	)		(801	)
Unearned compensation		(4,067	)		(6,182	)
Cumulative dividends in excess of net income		(26,230	)		(12,795	)
Total stockholders’ equity		520,342			347,478
Total liabilities and stockholders’ equity	$	975,454		$	724,641

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

3

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
REVENUE
Rooms	$	41,574		$	24,722		$	115,470		$	53,265
Food and beverage		16,765			9,698			52,195			23,482
Other		2,476			1,594			6,556			3,255
Total revenue		60,815			36,014			174,221			80,002
EXPENSES
Hotel operating expenses:
Rooms		9,452			5,879			26,077			11,969
Food and beverage		11,705			7,546			34,805			18,034
Other direct		1,119			910			3,202			1,987
Indirect		23,319			13,444			64,982			29,270
Total hotel operating expenses		45,595			27,779			129,066			61,260
Depreciation and amortization		6,297			3,192			16,311			6,918
Corporate general and administrative:
Stock-based compensation		775			758			2,432			2,348
Other		1,487			1,494			4,918			4,457
Total operating expenses		54,154			33,223			152,727			74,983
Operating income		6,661			2,791			21,494			5,019
Interest income		273			252			791			927
Interest expense		6,584			2,852			17,801			3,498
Foreign currency exchange gain		46			—			86			—
Income before income taxes and minority interest in operating partnership		396			191			4,570			2,448
Income tax benefit		432			392			536			959
Minority interest in operating partnership		(16	)		(14	)		(100	)		(80	)
Net income		812			569			5,006			3,327
Preferred stock dividends		(49	)		—			(49	)		—
Net income available to common stockholders	$	763		$	569		$	4,957		$	3,327
Net income per common share:
Basic	$	.02		$	.01		$	.12		$	.08
Diluted	$	.02		$	.01		$	.12		$	.08

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

4

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands, except share data)

(unaudited)

	Preferred Stock			Common Stock								Additional Paid-In Capital			Unearned Compensation			Cumulative Dividends in Excess of Net Income			Total
				Issued			Treasury
	Shares	Amount		Shares	Amount		Shares		Amount
Balances at December 31, 2004	—	$	—	40,002,011	$	400	(71,242	)	$	(801	)	$	366,856		$	(6,182	)	$	(12,795	)	$	347,478
Sale of common stock, net of underwriters’ fees and issuance costs	—		—	11,500,000		115	—			—			110,496			—			—			110,611
Sale of Series A Cumulative Redeemable Preferred Stock, net of underwriters’ fees and issuance costs	3,000,000		72,360	—		—	—			—			—			—			—			72,360
Issuance of common stock related to redemption of Operating Partnership units	—		—	142,688		1	—			—			1,225			—			—			1,226
Issuance of restricted common stock to employees	—		—	20,000		—	—			—			206			(206	)		—			—
Issuance of unrestricted common stock to directors	—		—	10,000		—	—			—			110			—			—			110
Purchase of treasury stock	—		—	—		—	(12,452	)		(135	)		—			—			—			(135	)
Amortization of unearned compensation	—		—	—		—	—			—			—			2,321			—			2,321
Adjustments to minority interest in operating partnership related to issuance of common stock and purchase of treasury stock	—		—	—		—	—			—			(194	)		—			—			(194	)
Declaration of dividends on common stock	—		—	—		—	—			—			—			—			(18,441	)		(18,441	)
Net income	—		—	—		—	—			—			—			—			5,006			5,006
Balances at September 30, 2005	3,000,000	$	72,360	51,674,699	$	516	(83,694	)	$	(936	)	$	478,699		$	(4,067	)	$	(26,230	)	$	520,342

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

5

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Nine Months Ended September 30,
	2005			2004
Cash flows from operating activities:
Net income	$	5,006		$	3,327
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		16,311			6,918
Amortization of deferred financing costs		786			64
Amortization of discount on mortgage loan		54			3
Change in fair value of interest rate swap		(408	)		(4	)
Minority interest in operating partnership		100			80
Stock-based compensation		2,432			2,348
Changes in assets and liabilities:
Accounts receivable, net		(7,066	)		(1,889	)
Prepaid expenses and other assets		(71	)		(1,768	)
Accounts payable and accrued expenses		2,554			7,665
Payable to affiliates		—			(1,328	)
Net cash provided by operating activities		19,698			15,416
Cash flows from investing activities:
Acquisition of hotel properties, net of cash acquired		(107,333	)		(416,743	)
Payment of value-added taxes (VAT) related to foreign hotel acquisition		(3,509	)		—
Deposit on hotel property acquisition		—			(8,000	)
Improvements and additions to hotel properties		(35,948	)		(2,568	)
Change in restricted cash		17,933			(37,465	)
Net cash used in investing activities		(128,857	)		(464,776	)
Cash flows from financing activities:
Proceeds from sale of common stock		110,888			—
Proceeds from sale of preferred stock		72,638			—
Payment of issuance costs related to sale of common and preferred stock		(555	)		(1,893	)
Purchase of treasury stock		(135	)		—
Proceeds from issuance of long-term debt		77,050			265,000
Principal payments on long-term debt		(2,971	)		(269	)
Payment of deferred financing costs		(324	)		(3,099	)
Deposit on loan application		(223	)		—
Payment of dividends to common stockholders		(16,809	)		(5,198	)
Payment of distributions to minority interests		(366	)		(125	)
Net cash provided by financing activities		239,193			254,416
Net increase (decrease) in cash		130,034			(194,944	)
Cash and cash equivalents, beginning of period		75,481			225,630
Cash and cash equivalents, end of period	$	205,515		$	30,686
Supplemental disclosure of cash flow information:
Cash paid for interest	$	17,758		$	3,155
Assumption of mortgage loans related to hotel acquisitions		—			28,343
Assumption of interest rate swap related to hotel acquisition		—			948
Issuance of Operating Partnership units in exchange for equity interests		—			125
Issuance of restricted common stock to employees		206			1,258
Issuance of unrestricted common stock to directors		110			129
Issuance of common stock related to redemption of Operating Partnership units		1,226			—

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

6

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Organization and Description of Business

Highland Hospitality Corporation (the “Company”) is a self-advised real estate investment trust (“REIT”) that was incorporated in Maryland in July 2003 to own upscale full-service, premium limited-service, and extended-stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside of the United States. The Company commenced operations on December 19, 2003 when it completed its initial public offering (“IPO”) and concurrently acquired three hotel properties. Since the IPO and the acquisition of its first three hotel properties, the Company has acquired 17 hotel properties. As of September 30, 2005, the Company owned 20 hotel properties with 5,885 rooms located in 11 states and Mexico.

Substantially all of the Company’s assets are held by, and all of its operations are conducted through, Highland Hospitality, L.P., a Delaware limited partnership (the “Operating Partnership”). For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which is owned approximately 98% by the Company and approximately 2% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels pursuant to management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

2. Summary of Significant Accounting Policies

Basis of Presentation—The consolidated financial statements presented herein include all of the accounts of Highland Hospitality Corporation and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

The information in these consolidated financial statements is unaudited but, in the opinion of management, reflects all adjustments necessary for a fair presentation of the results for the periods covered. All such adjustments are of a normal, recurring nature unless disclosed otherwise. These consolidated financial statements, including notes, have been prepared in accordance with the applicable rules of the Securities and Exchange Commission and do not include all of the information and disclosures required by U.S. generally accepted accounting principles for complete financial statements. Additional information is contained in the Highland Hospitality Corporation Form 10-K for the year ended December 31, 2004.

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 reserves held in escrow for hotel renovations, normal replacements of furniture, fixtures and equipment, real estate taxes, and insurance, pursuant to certain requirements in the Company’s hotel management, franchise, and loan agreements.

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 recognized as either assets or liabilities in 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 interest rate risk, are considered fair value hedges. Derivative instruments used to hedge the 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

7

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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.

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 consolidated statements of operations.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 15 to 40 years for buildings and building improvements and three to ten 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. No impairment losses have been recorded for the three and nine months ended September 30, 2005 and 2004.

The Company classifies a hotel property as held for sale in the period in which it has made the decision to dispose of the hotel property, a binding agreement to purchase the property has been signed under which the buyer has committed a significant amount of nonrefundable cash, and no significant financing contingencies exist which could cause the transaction not to be completed in a timely manner. If these criteria are met, depreciation of the hotel property will cease and an impairment loss will be recorded if the fair value of the hotel property, less the costs to sell, is lower than the carrying amount of the hotel property. The Company will classify the loss, together with the related operating results, as discontinued operations in the consolidated statements of operations and classify the assets and related liabilities as held for sale in the consolidated balance sheet.

The Company capitalizes interest related to hotel properties undergoing major renovations. Interest capitalized for the three and nine months ended September 30, 2005 was $50,000 and $0.3 million, respectively.

Minority Interest in Operating Partnership—Certain hotel properties have been acquired by the Operating Partnership, in part, 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 shares of the Company’s common stock and after each purchase of

8

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

treasury 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 parking, telephone and gift shop sales.

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

Debt Discounts or Premiums—Debt assumed in connection with hotel property acquisitions is recorded at fair value at the acquisition date and any resulting discount or premium is amortized through interest expense in the consolidated statements of operations over the remaining term of the debt.

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 (loss) that does not relate to HHC TRS, the Company’s wholly owned taxable REIT subsidiary. HHC TRS, which leases the Company’s hotels from the Operating Partnership, is subject to federal, state and foreign income taxes. In addition, the Operating Partnership’s subsidiary that owns the Barceló Tucancun Beach resort is subject to foreign 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. Valuation allowances are provided if based upon the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Earnings Per Share—Basic net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders, less dividends on unvested restricted common stock, by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per common share is calculated by dividing net income (loss) available to common stockholders, less dividends on unvested restricted common stock, by the weighted average number of common shares outstanding during the period, plus other potentially dilutive securities, such as unvested shares of restricted common stock and warrants. The outstanding Operating Partnership units (which may be redeemed for common shares) have been excluded from the diluted net income (loss) per common share calculation, as there would be no effect on reported diluted net income (loss) per common share.

Stock-Based Compensation—The Company accounts for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation. For restricted stock awards, the Company records unearned compensation equal to the number of shares awarded multiplied by the average price of the Company’s common stock on the date of the award, less the purchase price for the stock, if any. Unearned compensation is amortized using the straight-line method over the vesting period. For unrestricted stock awards, the Company records

9

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

compensation expense on the date of the award equal to the number of shares awarded multiplied by the closing price of the Company’s common stock on the date of the award, less the purchase price for the stock, if any.

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).

Treasury Stock—The Company records treasury stock purchases under the cost method whereby the entire cost of the acquired stock is recorded as treasury stock.

Foreign Currency—The U.S. dollar is the functional currency for the Company’s subsidiaries operating in Mexico. Monetary assets and liabilities are remeasured at the exchange rate in effect at the end of each period and nonmonetary assets and liabilities are remeasured at historical rates. Revenue and expenses denominated in a currency other than the U.S. dollar are remeasured into U.S. dollars at the average exchange rates in effect during each period. Gains and losses from foreign currency remeasurement are included in the consolidated statements of operations.

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

Use of Estimates—The preparation of the financial statements in conformity with U.S. generally accepted accounting principles 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.

New Accounting Pronouncements—Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment(“SFAS 123R”), requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The provisions of SFAS 123R will be effective as of January 1, 2006. Since the Company currently uses the fair value method of accounting for stock-based compensation, the adoption of SFAS 123R is not expected to have a material effect on the Company’s results of operations, financial position, or cash flows.

10

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

3. Acquisition of Hotel Properties

During 2004, the Company acquired 12 hotel properties, consisting of 3,623 rooms, for an aggregate purchase price of approximately $441.6 million, including the assumption of mortgage debt of approximately $28.3 million. The hotel acquisitions were funded with proceeds from the IPO, along with proceeds from the issuance of long-term debt during 2004. The hotel properties acquired were:

Property	Number of     Rooms	Location	Acquired
Hilton Tampa Westshore	238	Tampa, FL	January 8, 2004
Hilton Garden Inn BWI Airport	158	Linthicum, MD	January 12, 2004
Dallas/Fort Worth Airport Marriott	491	Dallas/Fort Worth, TX	May 10, 2004
Residence Inn Tampa Downtown	109	Tampa, FL	August 2, 2004
Courtyard Savannah Historic District	156	Savannah, GA	August 2, 2004
Hyatt Regency Wind Watch Long Island	360	Hauppauge, NY	August 19, 2004
Courtyard Boston Tremont	322	Boston, MA	August 19, 2004
Crowne Plaza Atlanta-Ravinia	495	Atlanta, GA	August 19, 2004
Hilton Parsippany	510	Parsippany, NJ	August 19, 2004
Radisson Mount Laurel	283	Mount Laurel, NJ	September 1, 2004
Omaha Marriott	299	Omaha, NE	September 15, 2004
Courtyard Denver Airport	202	Denver, CO	September 17, 2004
Total number of rooms	3,623

On February 4, 2005, the Company acquired the 196-room Sheraton Annapolis hotel in Annapolis, Maryland for approximately $18.4 million. The entity that sold the hotel is owned 33.3% by Barceló Corporación Empresarial, S.A. (“Barceló”), which is the parent company of Barceló Crestline Corporation (“Barceló Crestline”), which sponsored the Company’s formation and IPO. In conjunction with the acquisition, the Company assumed a lease agreement for the land underlying the hotel with an initial term ending September 2059. The Company concluded that the ground lease terms are below current market terms and recorded a $1.7 million favorable lease asset, which the Company is amortizing over the useful life of the building. The Company entered into a long-term agreement with Crestline Hotels & Resorts, Inc. to manage the hotel property.

On April 15, 2005, the Company acquired the 332-room Tucancun Beach Resort and Villas in Cancun, Mexico for approximately $32.5 million. The Company borrowed $15 million under its term loan facility to fund a portion of the acquisition. In conjunction with the acquisition, the Company paid $3.5 million of value-added taxes (VAT). The Company has filed a VAT refund request with the Mexican taxing authorities and recorded a $3.5 million receivable, which is included in prepaid expenses and other assets in the consolidated balance sheet. For Mexican property law purposes, legal title to the hotel is held by J.P. Morgan S.A., in trust for the Company, as the sole beneficiary. As the sole beneficiary of such trust, the Company can lease the hotel or cause J.P. Morgan S.A. to transfer title to the hotel. The Company converted the Tucancun Beach Resort and Villas to the Barceló brand and entered into long-term management and consulting agreements with separate subsidiaries of Barceló.

On July 14, 2005, the Company acquired the 410-room Wyndham Palm Springs hotel in Palm Springs, California for approximately $57.1 million. In conjunction with the acquisition, the Company assumed a sub-lease agreement for the land underlying the hotel with an initial term ending December 2059, with the right to extend the term an additional 25 years. The acquisition was funded with proceeds from the issuance of a $37.1

million loan, secured by the Wyndham Palm Springs hotel, and a portion of a $25 million borrowing under the Company’s term loan facility. The Company entered into a long-term agreement with Crestline Hotels & Resorts, Inc. to manage the property under a Wyndham license agreement.

11

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The combined allocation of the purchase prices to the acquired assets and liabilities based on their fair values was as follows (in thousands):

	2005 Acquisitions
Land and land improvements	$	6,218
Buildings and leasehold improvements		93,911
Furniture, fixtures and equipment		6,700
Cash		43
Accounts receivable, net		240
Prepaid assets and other assets		2,325
Accounts payable and accrued expenses		(1,388	)
Net assets acquired	$	108,049

The results of operations for each of the hotel properties are included in the Company’s consolidated statements of operations from their respective acquisition dates. The following pro forma financial information presents the results of operations of the Company for the three and nine months ended September 30, 2005 and 2004 as if the Sheraton Annapolis hotel, Tucancun Beach Resort and Villas, and Wyndham Palm Springs hotel acquisitions, as well as the 12 hotel acquisitions that occurred in 2004, had taken place on January 1, 2004. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually occurred had the transactions taken place on January 1, 2004, or of future results of operations (in thousands, except per share data).

	(unaudited) Three Months Ended September 30,					(unaudited) Nine Months Ended September 30,
	2005		2004			2005		2004
Total revenue	$	61,115	$	61,132		$	188,817	$	191,399
Total operating expenses		54,658		55,276			164,280		165,861
Operating income		6,457		5,856			24,537		25,538
Net income (loss)		483		(238	)		5,580		6,487
Net income (loss) available to common stockholders		434		(238	)		5,531		6,487
Net income (loss) per common share:
Basic		.01		(.01	)		.13		.16
Diluted		.01		(.01	)		.13		.16

4. Investment in Hotel Properties

Investment in hotel properties as of September 30, 2005 and December 31, 2004 consisted of the following (in thousands):

	September 30, 2005			December 31, 2004
Land and land improvements	$	73,532		$	67,314
Buildings and leasehold improvements		601,197			491,537
Furniture, fixtures and equipment		51,578			29,336
Construction-in-progress		9,049			4,550
		735,356			592,737
Less: accumulated depreciation and amortization		(30,333	)		(14,022	)
	$	705,023		$	578,715

12

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

5. Long-Term Debt

On April 13, 2005, the Company borrowed $15 million under its term loan facility to fund a portion of the Barceló Tucancun Beach resort acquisition. On July 11, 2005, the Company borrowed $25 million under its term loan facility to fund a portion of the Wyndham Palm Springs hotel acquisition. As of September 30, 2005, the Company had drawn down $90 million under the term loan facility.

On July 14, 2005, in connection with the Wyndham Palm Springs hotel acquisition, the Company completed a $37.1 million financing, secured by the Wyndham Palm Springs hotel. The loan bears a fixed annual interest rate of 5.35% and matures on August 1, 2012. Principal payments will commence in August 2007 and will be based on a 30-year amortization period. The loan agreement contains a standard provision that requires the loan servicer to maintain an escrow account over the term of the loan for real estate taxes.

In connection with the acquisition of the Hilton Parsippany hotel, the Crowne Plaza Atlanta-Ravinia hotel, the Hyatt Regency Wind Watch Long Island hotel, and the Courtyard Boston Tremont hotel, the Company completed a $160 million financing, comprised of a $135 million mortgage loan and a $25 million mezzanine loan. The loan agreements contain a restrictive provision that requires the loan servicer to retain in escrow excess cash flow from the encumbered hotel properties if net cash flow, as defined, for the trailing 12 months declines below a specified threshold. For the 12 months ended September 30, 2005, net cash flow from the four hotel properties did not exceed the specified threshold. Accordingly, the loan servicer has the right to retain in escrow excess cash flow from the four hotel properties until the hotels generate the minimum cash flow required for three consecutive months, at which time the cash being held in escrow will be released to the Company.

As of September 30, 2005, the Company was in compliance with the financial covenants contained in its other loan agreements.

6. Earnings Per Share

The following is a reconciliation of the amounts used in calculating basic and diluted net income per common share (in thousands, except share and per share data):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Numerator:
Net income available to common stockholders	$	763		$	569		$	4,957		$	3,327
Less: dividends on unvested restricted common stock		(88	)		(82	)		(260	)		(198	)
Net income available to common stockholders after dividends on unvested restricted common stock	$	675		$	487		$	4,697		$	3,129
Denominator:
Weighted average number of common shares outstanding—basic		39,835,652			39,092,011			39,557,325			39,085,659
Effect of dilutive securities:
Unvested restricted common stock		238,277			261,333			163,847			219,904
Warrants		93,120			71,934			66,144			87,707
Weighted average number of common shares outstanding—diluted		40,167,049			39,425,278			39,787,316			39,393,270
Net income per common share:
Basic	$	.02		$	.01		$	.12		$	.08
Diluted	$	.02		$	.01		$	.12		$	.08

13

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

7. Cash Distributions

On December 15, 2004, the Company’s board of directors declared a cash distribution to common stockholders of the Company and partners of the Operating Partnership of record as of December 31, 2004. The cash distribution of $.14 per common share and partnership unit was paid on January 14, 2005.

On March 10, 2005, the Company’s board of directors declared a cash distribution to common stockholders of the Company and partners of the Operating Partnership of record as of March 31, 2005. The cash distribution of $.14 per common share and partnership unit was paid on April 15, 2005.

On May 19, 2005, the Company’s board of directors declared a cash distribution to common stockholders of the Company and partners of the Operating Partnership of record as of June 30, 2005. The cash distribution of $.14 per common share and partnership unit was paid on July 15, 2005.

On September 17, 2005, the Company’s board of directors declared a cash distribution to common stockholders of the Company and partners of the Operating Partnership of record as of September 30, 2005. The cash distribution of $.14 per common share and partnership unit was paid on October 14, 2005.

8. Capital Stock

Common Stock—On September 28, 2005, the Company completed an underwritten public offering of 11,500,000 shares of common stock, including 1,500,000 shares issued as a result of the exercise of the underwriters’ over-allotment option. After deducting underwriting fees and issuance costs, the Company generated net proceeds of approximately $110.6 million.

Preferred Stock—On September 28, 2005, the Company completed an underwritten public offering of 3,000,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock. After deducting underwriting fees and issuance costs, the Company generated net proceeds of approximately $72.4 million.

Holders of Series A Cumulative Redeemable Preferred Stock are entitled to receive, when and as authorized by the Company’s board of directors, out of funds legally available for the payment of dividends, cumulative cash dividends at the rate of 7.875% per annum of the $25 per share liquidation preference, equivalent to $1.96875 per annum per share. Dividends on the Series A Cumulative Redeemable Preferred Stock are cumulative from the date of original issuance and will be payable quarterly in arrears on or about the 15th day of each of February, May, August and November. The Series A Cumulative Redeemable Preferred Stock ranks senior to the Company’s common stock with respect to the payment of dividends; the Company will not declare or pay any dividends, or set aside any funds for the payment of dividends, on its common stock unless the Company also has declared and either paid or set aside for payment the dividends on the Series A Cumulative Redeemable Preferred Stock.

The Company cannot redeem the Series A Cumulative Redeemable Preferred Stock prior to September 28, 2010, except in certain limited circumstances related to the ownership limitation necessary to preserve the Company’s qualification as a REIT. On and after September 28, 2010, the Company, at its option, can redeem the Series A Cumulative Redeemable Preferred Stock, in whole or from time to time in part, at a redemption price of $25 per share, plus any accrued and unpaid dividends. In general, the holders of Series A Cumulative Redeemable Preferred Stock have no voting rights.

Treasury Stock—For the nine months ended September 30, 2005, the Company purchased 12,452 shares of common stock from employees to satisfy the minimum statutory tax withholding requirements related to the vesting of their shares of restricted common stock.

14

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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, at the sole discretion of the Operating Partnership, either shares of the Company’s common stock on a one-for-one basis or 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.

In February 2005, a limited partner caused the Operating Partnership to redeem its units in exchange for 142,688 shares of the Company’s common stock. As of September 30, 2005, the total number of Operating Partnership units outstanding owned by third-party limited partners was 824,523.

9. Related-Party Transactions

On February 4, 2005, the Company acquired the 196-room Sheraton Annapolis hotel in Annapolis, Maryland for approximately $18.4 million. The entity that sold the hotel is owned 33.3% by Barceló Corporación Empresarial, S.A., which is the parent company of Barceló Crestline Corporation, which sponsored the Company’s formation and IPO.

Management Agreements—As of September 30, 2005, 11 of the Company’s 20 hotels operated pursuant to management agreements with Crestline Hotels & Resorts, Inc., which is a wholly owned subsidiary of Barceló Crestline, each for a 10-year term. Crestline Hotels & Resorts receives a base management fee, and if the hotels meet and exceed certain performance thresholds, an incentive management fee. The base management fee for the hotels is generally between 2% and 3.5% of total gross revenues from the hotels. The incentive management fee, if any, for each hotel will be due annually in arrears within 105 days after the end of each fiscal year and will be equal to 15% of the amount by which operating income for the fiscal year exceeds 11% of the Company’s capitalized investment in the hotel. Crestline Hotels & Resorts will not be entitled to receive any incentive fee in any fiscal year in which the operating income of the hotel has not equaled at least 11% of the Company’s capitalized investment in the hotel. The management agreements place a cap on the total amount of combined base and incentive management fees paid to Crestline Hotels & Resorts at 4.5% of gross revenues for each fiscal year.

For the three months ended September 30, 2005 and 2004, the Company paid Crestline Hotels & Resorts approximately $0.7 million and $0.4 million, respectively, in management fees. For the nine months ended September 30, 2005 and 2004, the Company paid Crestline Hotels & Resorts approximately $2.1 million and $1.1 million, respectively, in management fees.

As of September 30, 2005, the Barceló Tucancun Beach resort operated pursuant to management and consulting agreements with separate subsidiaries of Barceló. The initial term of the management agreement is five years and will be automatically extended for four successive five-year periods, unless terminated because of a default of the manager or the manager elects not to renew. Barceló receives a base management fee, and if the hotel meets and exceeds a certain performance threshold, an incentive management fee. The base management fee is 3% of total gross revenues from the hotel. The incentive management fee, if any, will be equal to 15% of the amount by which operating income for the fiscal year exceeds 12% of the Company’s capitalized investment in the hotel. Barceló will not be entitled to receive any incentive fee in any fiscal year in which the operating income of the hotel has not equaled at least 12% of the Company’s capitalized investment in the hotel. The management agreement places a cap on the total amount of combined base and incentive management fees paid to Barceló at 7.5% of gross revenues for each fiscal year.

The consulting agreement is coterminous with the management agreement; provided, however, that Barceló can terminate the consulting agreement upon 90 days notice. Pursuant to the consulting agreement, Barceló will

15

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

provide consulting services with respect to the operation of the Barceló Tucancun Beach resort. The consulting fee will be based on the time spent by Barceló in providing such services and will be agreed upon by Barceló and the Company each year; provided, however, that the consulting fee paid to Barceló each year is not expected to exceed 15% of the total fees payable to Barceló that same year under the management agreement.

For the three and nine months ended September 30, 2005, the Company paid separate subsidiaries of Barceló approximately $73,000 and $143,000, respectively, in management and consulting fees.

Overhead and Cost-Sharing Arrangement—Since the Company’s inception, it has had an informal overhead and cost-sharing arrangement with Barceló Crestline whereby the Company has shared Barceló Crestline’s office space and related furniture, fixtures and equipment and certain support services, including human resources and information technology functions, in exchange for a monthly reimbursement of the estimated value to the Company from this sharing arrangement. For the three months ended September 30, 2005 and 2004, the Company paid Barceló Crestline approximately $36,000 and $70,000, respectively, under this arrangement. For the nine months ended September 30, 2005 and 2004, the Company paid Barceló Crestline approximately $162,000 and $210,000, respectively, under this arrangement.

10. Commitments and Contingencies

Ground and Building Leases—The Company leases the Portsmouth Renaissance hotel and adjoining conference center from the Industrial Development Authority of the City of Portsmouth pursuant to two separate lease agreements, each for an initial term of 50 years ending May 2049, with four ten-year renewal options and one nine-year renewal option. Base rent under the hotel lease is $50,000 per year. Annual percentage rent is equal to 100% of available net cash flow after payment of all hotel operating expenses, the base rent, real estate and property taxes, insurance and a cumulative priority annual return to the lessee of approximately $2 million, up to $0.2 million, then 50% of any remaining net cash flow until the landlord has been paid percentage (and additional) rent of $10 million in aggregate, and thereafter 10% of net cash flow annually. If the Company sells or assigns the hotel lease to an unrelated party, an additional rent payment equal to 50% of the net sales proceeds in excess of the Company’s capital investment in the hotel and unpaid annual return of 15% on the investment will be due.

Annual rent under the conference center lease is equal to the lesser of $75,000 per year or the maximum amount of rent allowable under tax regulations so as to preserve the tax-exempt status of the Portsmouth Industrial Development Authority bonds issued in connection with the hotel and conference center.

The Company leases the conference center and parking facility adjoining the Sugar Land Marriott hotel from the Sugar Land Town Square Development Authority for a term of 99 years ending October 2102. The minimum rent is $1 per year, plus an incentive rent payment for the first 25 years of the term of the lease. If during any of those first 25 years, the Company’s cumulative internal rate of return on investment in the hotel exceeds 15%, then the Company will pay incentive rent in an amount equal to 36% of the net cash flow and/or net sale proceeds for the applicable year in excess of the amount of net cash flow and/or net sales proceeds that would be necessary to generate a cumulative internal rate of return of 15%.

Percentage and incentive rent is accrued when it becomes probable that the specified thresholds will be achieved. No percentage rent was owed, as the thresholds were not met in any period presented in the financial statements.

The Company leases the land underlying the Sheraton Annapolis hotel pursuant to a lease agreement with an initial term ending September 2059. Annual rent due under the lease is approximately $0.3 million and

16

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

increases each year over the remaining term of the lease by 40% of the increase in the Consumer Price Index (CPI) for that year. In addition, the land will be appraised every five years and the annual rent will be increased to an amount equal to the product of the appraised value and 12%. However, annual rent will not be increased by an amount greater than 10% of the annual rent for the preceding year.

The Company leases the land underlying the Wyndham Palm Springs hotel pursuant to a sub-lease agreement with an initial term ending December 2059, with the right to extend the term an additional 25 years. Annual rent due under the lease is the greater of base rent or percentage rent. Base rent for the years 2005 through 2009 is approximately $0.9 million. Base rent increases every five years over the remaining term of the lease by the increase in the CPI over that same five-year period; however, the increase in base rent every five years will not be increased by an amount greater than 30% of the base rent for the preceding five-year period. Annual percentage rent is equal to the sum of 4% of rooms gross receipts, 2% of food and beverage gross receipts, and 10% of tenant rentals.

Management Agreements—As of September 30, 2005, the Company’s hotel properties operated pursuant to long-term agreements with six management companies, including Crestline Hotels & Resorts, Inc. (11 hotels), Marriott International, Inc. (3 hotels), Hyatt Corporation (2 hotels), McKibbon Hotel Management, Inc. (2 hotels), Sage Hospitality Resources (1 hotel), and Grubarges Gestión Hotelera Mexicana SA de CV (1 resort). Each management company receives a base management fee generally between 2% and 4% of hotel revenues. The management companies are also eligible to receive an incentive management fee if hotel operating income, as defined in the management agreements, exceeds certain thresholds. The incentive management fee is generally calculated as a percentage of hotel operating income after the Company has received a priority return on its investment in the hotel.

Franchise Agreements—As of September 30, 2005, 14 of the Company’s 20 hotel properties operated pursuant to franchise agreements from national hotel companies. Pursuant to the franchise agreements, the Company pays a royalty fee generally between 4% and 5% of room revenues, plus additional fees for marketing, central reservation systems, and other franchisor costs that amount to between 3% and 4% of room revenues from the hotels. Five of the Company’s 20 hotel properties, which include the Hyatt Regency Savannah hotel, the Hyatt Regency Wind Watch Long Island hotel, the Dallas/Fort Worth Airport Marriott hotel, the Courtyard Boston Tremont hotel, and the Courtyard Denver Airport hotel, are managed by Hyatt Corporation or Marriott International, Inc. The management agreements for these five hotel properties allow the hotel property to operate under the respective brand. The management agreement for the Barceló Tucancun Beach resort allows the hotel property to operate under the Barceló brand.

Property Improvement Reserves—Pursuant to its management, franchise and loan agreements, the Company is required to establish a property improvement reserve for each hotel to cover the cost of replacing furniture, fixtures and equipment at the hotels. Contributions to the property improvement reserve are based on a percentage of gross revenues or receipts at each hotel. The Company is generally required to contribute between 3% and 5% of gross revenues each month over the term of the agreements.

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

11. Subsequent Events

On October 5, 2005, the Company sold an additional 200,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock as a result of the exercise of the underwriters’ over-allotment option. After deducting underwriting fees and issuance costs, the Company generated net proceeds of approximately $4.8 million.

17

HIGHLAND HOSPITALITY CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

On October 7, 2005, the Company completed a $10 million financing secured by the Sheraton Annapolis hotel. The loan bears a fixed annual interest rate of 5.21% and matures on November 1, 2012. Principal payments will commence in November 2007 and will be based on a 30-year amortization period. The loan agreement contains a standard provision that requires the loan servicer to maintain an escrow account over the term of the loan for real estate taxes.

On October 22, 2005, Hurricane Wilma made landfall in Cancun, Mexico causing wind and water damage to the Barceló Tucancun Beach resort. The damage was concentrated on the grounds of the hotel, as well as the first level of the hotel, including significant structural damage to the sea wall and flood damage to the lobby, restaurant and pool areas. As of the date hereof, the resort is closed. The Company is currently working with Barceló and its insurance carrier to assess the extent of the property damage and loss of business. The Company’s insurance coverage for the property entitles it to receive payments for business interruption, as well as recoveries for damage to the property as a result of the hurricane. Income resulting from business interruption insurance will not be recognized until all contingencies are resolved.

On October 24, 2005, the Company acquired the 385-room Hilton Boston Back Bay hotel in Boston, Massachusetts for $110 million, plus customary closing costs. The Company entered into a long-term agreement with Hilton Hotels Corporation to manage the hotel property.

On October 31, 2005, the Company entered into a definitive agreement to acquire the 294-room Westin Princeton at Forrestal Village in Princeton, New Jersey from Starwood Hotels & Resorts for $53.5 million, plus customary closing costs.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

Highland Hospitality Corporation is a self-advised REIT that was incorporated in July 2003 to own upscale full-service, premium limited-service, and extended-stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside of the United States. We commenced operations on December 19, 2003 when we completed our IPO and concurrently acquired three hotel properties. Since the IPO and the acquisition of our first three hotel properties, we have acquired 17 hotel properties (not including the 385-room Hilton Boston Back Bay hotel acquired on October 24, 2005). As of September 30, 2005, we owned the following 20 hotel properties:

Property	Number of     Rooms	Location	Acquired
Portsmouth Renaissance and Conference Center	249	Portsmouth, VA	December 19, 2003
Sugar Land Marriott and Conference Center	300	Sugar Land, TX	December 19, 2003
Hilton Garden Inn Virginia Beach Town Center	176	Virginia Beach, VA	December 19, 2003
Plaza San Antonio Marriott	252	San Antonio, TX	December 29, 2003
Hyatt Regency Savannah	347	Savannah, GA	December 30, 2003
Hilton Tampa Westshore	238	Tampa, FL	January 8, 2004
Hilton Garden Inn BWI Airport	158	Linthicum, MD	January 12, 2004
Dallas/Fort Worth Airport Marriott	491	Dallas/Fort Worth, TX	May 10, 2004
Residence Inn Tampa Downtown	109	Tampa, FL	August 2, 2004
Courtyard Savannah Historic District	156	Savannah, GA	August 2, 2004
Hyatt Regency Wind Watch Long Island	360	Hauppauge, NY	August 19, 2004
Courtyard Boston Tremont	322	Boston, MA	August 19, 2004
Crowne Plaza Atlanta-Ravinia	495	Atlanta, GA	August 19, 2004
Hilton Parsippany	510	Parsippany, NJ	August 19, 2004
Radisson Mount Laurel	283	Mount Laurel, NJ	September 1, 2004
Omaha Marriott	299	Omaha, NE	September 15, 2004
Courtyard Denver Airport	202	Denver, CO	September 17, 2004
Sheraton Annapolis	196	Annapolis, MD	February 4, 2005
Barceló Tucancun Beach	332	Cancun, Mexico	April 15, 2005
Wyndham Palm Springs	410	Palm Springs, CA	July 14, 2005
Total number of rooms	5,885

Substantially all of our assets are held by, and all of our operations are conducted through, Highland Hospitality, L.P. (our “Operating Partnership”). In order for us to qualify as a REIT, neither our company nor the Operating Partnership can operate hotels directly. Therefore, the Operating Partnership, which is owned approximately 98% by us and approximately 2% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels pursuant to management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

Key Operating Metrics

Hotel results of operations are best explained by three key performance indicators: occupancy, average daily rate (“ADR”) and revenue per available room (“RevPAR”), which is room revenue divided by total number of room nights. RevPAR does not include food and beverage revenues or other ancillary revenues, such as telephone, parking or other guest services provided by the property.

Occupancy is a major driver of room revenue, as well as other revenue categories, such as food and beverage and telephone. ADR helps to drive room revenue as well; however, it does not have a direct effect on

19

other revenue categories. Fluctuations in occupancy are accompanied by fluctuations in most categories of variable operating costs, such as utility costs and certain labor costs such as housekeeping, resulting in varying levels of hotel profitability. Increases in ADR typically result in higher hotel profitability since variable hotel expenses generally do not increase correspondingly. Thus, increases in RevPAR attributable to increases in occupancy are accompanied by increases in most categories of variable operating costs, while increases in RevPAR attributable to increases in ADR are accompanied by increases in limited categories of operating costs, such as management fees and franchise fees.

Executive Summary of Third Quarter Events

The lodging industry continued to demonstrate strong operating fundamentals during the third quarter 2005. According to Smith Travel Research (“STR”), RevPAR industry wide in the United States increased 8.3% for the three months ended September 30, 2005, as compared to the same period in 2004. For the third quarter 2005, demand growth for hotel rooms continued to outpace supply growth. According to STR, for the three months ended September 30, 2005, demand for hotel rooms increased by 3.0% and supply growth increased 0.4%, as compared to the same period in 2004. With demand growth expected to continue to outpace supply growth over the next couple of years, industry occupancy should continue to move higher and position our industry for additional pricing power.

We were pleased with the performance of our hotel portfolio in the third quarter 2005. We continue to assess the performance of our portfolio based on two categories: stabilized hotels and rebranded/renovated hotels. Rebranded/renovated includes hotels that are currently going through, or have recently gone through, significant renovation and/or in the process of changing, or have recently changed, their franchise affiliation. Stabilized includes hotels that are not being disrupted by renovation or rebranding efforts. We continued to see strong RevPAR increases for our stabilized hotels in the third quarter 2005. For the third quarter 2005, RevPAR for our stabilized hotels increased 9.8% as compared to the third quarter 2004. In addition, our stabilized hotels’ operating margins continued to improve during the third quarter 2005. Hotel operating income for our stabilized hotels increased 23.6% to $8.0 million in the third quarter 2005 as compared to the third quarter 2004, and hotel operating income margins increased 3.4 percentage points to 28.7%.

As for our rebranded/renovated hotels, our renovation and rebranding efforts continued to adversely impact our overall hotel portfolio’s results in the third quarter 2005. For the third quarter 2005, RevPAR for the rebranded/renovated hotels decreased 0.2% as compared to the third quarter 2004. Hotel operating income for the rebranded/renovated hotels increased 1.2% to $6.7 million in the third quarter 2005 as compared to the third quarter 2004, and hotel operating income margins increased 0.6 percentage points to 24.0%. Although the rebranded/renovated hotels trailed our stabilized hotels in terms of RevPAR and hotel operating income margin increases in the third quarter 2005 versus third quarter 2004, we continued to see significant improvements from the similar comparisons in the first quarter and second quarter. A large part of the improvements can be attributed to the higher ADRs we are achieving as rooms come back on line at the renovated properties. For the third quarter 2005, ADR for the rebranded/renovated hotels increased 8.1% as compared to the third quarter 2004.

As of September 30, 2005, renovation activities had been completed at the Plaza San Antonio Marriott hotel, the Hyatt Regency Savannah hotel, the Crowne Plaza Atlanta-Ravinia hotel, and the Hyatt Regency Wind Watch Long Island hotel. Renovation activities continued during the third quarter 2005 at the Hilton Parsippany hotel, the Courtyard Boston Tremont hotel, and the Radisson Mount Laurel hotel and are expected to continue through the remainder of 2005 and into 2006. We continue to believe that the renovation and rebranding efforts that have taken place to-date and will continue over the next couple of quarters will position us well to take advantage of the continuing recovery in the lodging industry in 2006 and 2007.

At the end of the third quarter 2005, we completed underwritten public offerings of common stock and Series A Cumulative Redeemable Preferred Stock. Including the exercise of the underwriters’ over-allotment

20

options, we generated net proceeds, after underwriters’ fees and issuance costs, of approximately $188 million. On October 24, 2005, we acquired the Hilton Boston Back Bay hotel in Boston, Massachusetts for $110 million. On October 31, 2005, we announced the signing of a definitive agreement to acquire the 294-room Westin Princeton at Forrestal Village in Princeton, New Jersey from Starwood Hotels & Resorts for $53.5 million. We continue to actively pursue investment opportunities in the United States, but we will be prudent in spending capital given the competitive hotel acquisition environment.

On October 22, 2005, Hurricane Wilma made landfall in Cancun, Mexico causing wind and water damage to the Barceló Tucancun Beach resort. The damage was concentrated on the grounds of the hotel, as well as the first level of the hotel, including significant structural damage to the sea wall and flood damage to the lobby, restaurant and pool areas. The resort is currently closed, and based on the initial assessment of the damage, we do not expect it to open for business before the end of 2005. We are currently working with Barceló and our insurance carrier to assess the extent of the property damage and loss of business. Our insurance coverage for the property entitles us to receive payments for business interruption, as well as recoveries for damage to the property as a result of the hurricane. Income resulting from business interruption insurance will not be recognized until all contingencies are resolved. We expect that insurance proceeds will be sufficient to cover the property damage to the hotel and the near-term loss of business.

Results of Operations

Comparison of three months ended September 30, 2005 and 2004

Results of operations for the three months ended September 30, 2005 include the operating activity of 19 hotels for a full quarter and one hotel for a partial quarter. Results of operations for the three months ended September 30, 2004 include the operating activity of eight hotels for a full quarter and nine hotels for a partial quarter (see table above for hotel property acquisition dates). As such, comparisons of results of operations for the three months ended September 30, 2005 versus the three months ended September 30, 2004 are not meaningful due to the lack of comparability.

Revenues—Total revenue for the three months ended September 30, 2005 was $60.8 million, as compared to $36.0 million for the comparable period in 2004. Total revenue for the three months ended September 30, 2005 included rooms revenue of $41.6 million, food and beverage revenue of $16.8 million, and other revenue of $2.5 million. Total revenue for the three months ended September 30, 2004 included rooms revenue of $24.7 million, food and beverage revenue of $9.7 million, and other revenue of $1.6 million.

Included in the following table is a comparison of the key operating metrics for our hotel portfolio for the three months ended September 30, 2005 and 2004. The comparison does not include results of operations for the Wyndham Palm Springs hotel, which was acquired on July 14, 2005, and the Barceló Tucancun Beach resort. Since 10 of our hotels owned as of September 30, 2005 were acquired at various times in the three months ended September 30, 2004 and in 2005, the key operating metrics for those 10 hotels reflect the results of operations of the hotels under previous ownership for either a portion of, or the entire, three months ended September 30, 2004. Management currently assesses the performance of its hotel portfolio based on two categories: stabilized and rebranded/renovated. Rebranded/renovated includes hotels that are currently going through, or have recently gone through, significant renovation and/or in the process of changing, or have recently changed, their franchise affiliation. Stabilized includes hotels that are not being disrupted by renovation or rebranding efforts.

	Three Months Ended September 30,
	2005						2004 (Pro Forma)
	Occ %		ADR		RevPAR		Occ %		ADR		RevPAR
Stabilized (11 hotels)	75.7	%	$	113.18	$	85.67	73.1	%	$	106.83	$	78.05
Rebranded/Renovated (7 hotels)	67.3	%	$	120.56	$	81.19	73.0	%	$	111.48	$	81.37
Total (18 hotels)	71.5	%	$	116.68	$	83.41	73.0	%	$	109.17	$	79.72

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For the three months ended September 30, 2005, RevPAR for our stabilized hotels increased 9.8% to $85.67 from the comparable period in 2004. Occupancy increased by 2.6 percentage points to 75.7%, while ADR increased by 5.9%. For our rebranded/renovated hotels, RevPAR decreased 0.2% to $81.19 from the comparable period in 2004. Occupancy decreased by 5.7 percentage points to 67.3%, while ADR increased by 8.1%. For the total 18 hotels, RevPAR increased by 4.6% to $83.41 from the comparable period in 2004. Occupancy decreased by 1.5 percentage points to 71.5%, while ADR increased by 6.9%.

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the three months ended September 30, 2005 were $45.6 million, as compared to $27.8 million for the comparable period in 2004. Direct hotel operating expenses for the three months ended September 30, 2005 included rooms expenses of $9.5 million, food and beverage expenses of $11.7 million, and other direct expenses of $1.1 million. Direct hotel operating expenses for the three months ended September 30, 2004 included rooms expenses of $5.9 million, food and beverage expenses of $7.5 million, and other direct expenses of $0.9 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, for the three months ended September 30, 2005 were $23.3 million, as compared to $13.4 million for the comparable period in 2004.

Hotel operating income and margins—Included in the following table is a comparison of hotel operating income (hotel revenues less hotel operating expenses) and hotel operating income margins (hotel operating income divided by hotel revenues) for our hotel portfolio for the three months ended September 30, 2005 and 2004. The comparison does not include results of operations for the Wyndham Palm Springs hotel and the Barceló Tucancun Beach resort. Since 10 of our hotels owned as of September 30, 2005 were acquired at various times in the three months ended September 30, 2004 and in 2005, the hotel operating income and hotel operating income margins for those 10 hotels reflect the results of operations of the hotels under previous ownership for either a portion of, or the entire, three months ended September 30, 2004.

	Three Months Ended September 30,
	2005				2004 (Pro Forma)
	$ (1)		%		$ (1)		%
Stabilized (11 hotels)	$	8.0	28.7	%	$	6.5	25.3	%
Rebranded/Renovated (7 hotels)	$	6.7	24.0	%	$	6.6	23.4	%
Total (18 hotels)	$	14.7	26.4	%	$	13.1	24.3	%

(1) in millions

For the three months ended September 30, 2005, hotel operating income for our stabilized hotels increased 23.6% to $8.0 million from the comparable period in 2004 and hotel operating income margins increased by 3.4 percentage points to 28.7%. For our rebranded/renovated hotels, hotel operating income increased 1.2% to $6.7 million from the comparable period in 2004 and hotel operating income margins increased by 0.6 percentage points to 24.0%. For the total 18 hotels, hotel operating income increased by 12.3% to $14.7 million from the comparable period in 2004 and hotel operating income margins increased by 2.1 percentage points to 26.4%.

Depreciation and amortization—Depreciation and amortization expense for the three months ended September 30, 2005 was $6.3 million, as compared to $3.2 million for the comparable period in 2004.

Corporate general and administrative—Total corporate general and administrative expenses for the three months ended September 30, 2005 and 2004 were $2.3 million. Included in corporate general and administrative expenses for the three months ended September 30, 2005 and 2004 was $0.8 million of non-cash stock-based compensation expense.

Interest income—Interest income for the three months ended September 30, 2005 and 2004 was $0.3 million.

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Interest expense—Interest expense for the three months ended September 30, 2005 was $6.6 million, as compared to $2.9 million for the comparable period in 2004. As of September 30, 2005, our weighted average interest rate on our long-term debt was 6.35%.

Income tax benefit—Income tax benefit for the three months ended September 30, 2005 and 2004 was $0.4 million. The income tax benefits resulted primarily from taxable operating losses incurred by our TRS for the three months ended September 30, 2005 and 2004.

Net income—Net income for the three months ended September 30, 2005 was $0.8 million, as compared to $0.6 million for the comparable period in 2004, due to the items discussed above.

Comparison of nine months ended September 30, 2005 and 2004

Results of operations for the nine months ended September 30, 2005 include the operating activity of 17 hotels for a full nine months and three hotels for a partial nine months. Results of operations for the nine months ended September 30, 2004 include the operating activity of five hotels for a full nine months and 12 hotels for a partial nine months (see table above for hotel property acquisition dates). As such, comparisons of results of operations for the nine months ended September 30, 2005 versus the nine months ended September 30, 2004 are not meaningful due to the lack of comparability.

Revenues—Total revenue for the nine months ended September 30, 2005 was $174.2 million, as compared to $80.0 million for the comparable period in 2004. Total revenue for the nine months ended September 30, 2005 included rooms revenue of $115.5 million, food and beverage revenue of $52.2 million, and other revenue of $6.6 million. Total revenue for the nine months ended September 30, 2004 included rooms revenue of $53.3 million, food and beverage revenue of $23.5 million, and other revenue of $3.3 million.

Included in the following table is a comparison of the key operating metrics for our hotel portfolio for the nine months ended September 30, 2005 and 2004. The comparison does not include results of operations for the Wyndham Palm Springs hotel, which was acquired on July 14, 2005, and the Barceló Tucancun Beach resort. Since 13 of our hotels owned as of September 30, 2005 were acquired at various times in 2004 and 2005, the key operating metrics for those 13 hotels reflect the results of operations of the hotels under previous ownership for either a portion of, or the entire, nine months ended September 30, 2004.

	Nine Months Ended September 30,
	2005						2004 (Pro Forma)
	Occ %		ADR		RevPAR		Occ %		ADR		RevPAR
Stabilized (11 hotels)	76.0	%	$	114.63	$	87.12	72.9	%	$	108.08	$	78.80
Rebranded/Renovated (7 hotels)	62.2	%	$	120.95	$	75.18	70.6	%	$	114.59	$	80.91
Total (18 hotels)	69.0	%	$	117.51	$	81.09	71.7	%	$	111.32	$	79.87

For the nine months ended September 30, 2005, RevPAR for our stabilized hotels increased 10.6% to $87.12 from the comparable period in 2004. Occupancy increased by 3.1 percentage points to 76.0%, while ADR increased by 6.1%. For our rebranded/renovated hotels, RevPAR decreased 7.1% to $75.18 from the comparable period in 2004. Occupancy decreased by 8.4 percentage points to 62.2%, while ADR increased by 5.6%. For the total 18 hotels, RevPAR increased by 1.5% to $81.09 from the comparable period in 2004. Occupancy decreased by 2.7 percentage points to 69.0%, while ADR increased by 5.6%.

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the nine months ended September 30, 2005 were $129.1 million, as compared to $61.3 million for the comparable period in 2004. Direct hotel operating expenses for the nine months ended September 30, 2005 included rooms expenses of $26.1 million, food and beverage expenses of $34.8 million, and other direct expenses of $3.2 million. Direct hotel operating expenses for the nine months ended September 30, 2004 included rooms expenses of $12.0

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million, food and beverage expenses of $18.0 million, and other direct expenses of $2.0 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, for the nine months ended September 30, 2005 were $65.0 million, as compared to $29.3 million for the comparable period in 2004.

Hotel operating income and margins—Included in the following table is a comparison of hotel operating income and hotel operating income margins for our hotel portfolio for the nine months ended September 30, 2005 and 2004. The comparison does not include results of operations for the Wyndham Palm Springs hotel and the Barceló Tucancun Beach resort. Since 13 of our hotels owned as of September 30, 2005 were acquired at various times in 2004 and 2005, the hotel operating income and hotel operating income margins for those 13 hotels reflect the results of operations of the hotels under previous ownership for either a portion of, or the entire, nine months ended September 30, 2004.

	Nine Months Ended September 30,
	2005				2004 (Pro Forma)
	$ (1)		%		$ (1)		%
Stabilized (11 hotels)	$	25.9	30.1	%	$	20.4	25.9	%
Rebranded/Renovated (7 hotels)	$	17.9	22.2	%	$	21.3	24.3	%
Total (18 hotels)	$	43.8	26.3	%	$	41.7	25.1	%

(1) in millions

For the nine months ended September 30, 2005, hotel operating income for our stabilized hotels increased 27.0% to $25.9 million from the comparable period in 2004 and hotel operating income margins increased by 4.2 percentage points to 30.1%. For our rebranded/renovated hotels, hotel operating income decreased 16.2% to $17.9 million from the comparable period in 2004 and hotel operating income margins decreased by 2.1 percentage points to 22.2%. For the total 18 hotels, hotel operating income increased by 4.9% to $43.8 million from the comparable period in 2004 and hotel operating income margins increased by 1.2 percentage points to 26.3%.

Depreciation and amortization—Depreciation and amortization expense for the nine months ended September 30, 2005 was $16.3 million, as compared to $6.9 million for the comparable period in 2004.

Corporate general and administrative—Total corporate general and administrative expenses for the nine months ended September 30, 2005 were $7.4 million, as compared to $6.8 million for the comparable period in 2004. Included in corporate general and administrative expenses for the nine months ended September 30, 2005 and 2004 was $2.4 million and $2.3 million, respectively, of non-cash stock-based compensation expense.

Interest income—Interest income for the nine months ended September 30, 2005 and 2004 was $0.8 million and $0.9 million, respectively.

Interest expense—Interest expense for the nine months ended September 30, 2005 was $17.8 million, as compared to $3.5 million for the comparable period in 2004.

Income tax benefit—Income tax benefit for the nine months ended September 30, 2005 was $0.5 million, as compared to $1.0 million for the comparable period in 2004. The income tax benefits resulted primarily from taxable operating losses incurred by our TRS for the nine months ended September 30, 2005 and 2004.

Net income—Net income for the nine months ended September 30, 2005 was $5.0 million, as compared to $3.3 million for the comparable period in 2004, due to the items discussed above.

Non-GAAP Financial Measures

Funds from operations—Funds from operations, or FFO, is defined as net income (loss), plus real estate related depreciation and amortization. FFO available to common stockholders is defined as FFO less preferred

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stock dividends. Historical cost accounting for real estate assets 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, most industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Accordingly, we believe that FFO and FFO available to common stockholders are useful financial performance measures for investors and management because they provide another indication of our performance prior to deduction of real estate related depreciation and amortization. The calculation of FFO and FFO available to common stockholders may vary from entity to entity, and as such, the presentation of FFO and FFO available to common stockholders by us may not be comparable to FFO and FFO available to common stockholders reported by other REITs. The following is a reconciliation between net income, FFO and FFO available to common stockholders (in thousands):

	Three Months Ended September 30,					Nine Months Ended September 30,
	2005			2004		2005			2004
Net income	$	812		$	569	$	5,006		$	3,327
Adjustment: Depreciation and amortization		6,297			3,192		16,311			6,918
FFO		7,109			3,761		21,317			10,245
Adjustment: Preferred stock dividends		(49	)		—		(49	)		—
FFO available to common stockholders	$	7,060		$	3,761	$	21,268		$	10,245

EBITDA—EBITDA is defined as net income (loss) before interest, income taxes, depreciation and amortization. We believe it is a useful financial performance measure for investors and management because it provides an indication of the operating performance of our hotel properties and is not impacted by the capital structure of the REIT. The following is a reconciliation between net income and EBITDA (in thousands):

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Net income	$	812		$	569		$	5,006		$	3,327
Adjustments: Depreciation and amortization		6,297			3,192			16,311			6,918
Interest expense		6,584			2,852			17,801			3,498
Interest income		(273	)		(252	)		(791	)		(927	)
Income tax benefit		(432	)		(392	)		(536	)		(959	)
EBITDA	$	12,988		$	5,969		$	37,791		$	11,857

Neither FFO, FFO available to common stockholders, nor EBITDA represent cash generated from operating activities as determined by U.S. generally accepted accounting principles (“GAAP”) and neither should be considered as an alternative to GAAP net income, as an indication of our financial performance, or to cash flow from operating activities as determined by GAAP, as a measure of liquidity. In addition, FFO, FFO available to common stockholders, and EBITDA are not indicative of funds available to fund cash needs, including the ability to make cash distributions.

Liquidity and Capital Resources

Our principal source of cash to meet our operating requirements, including distributions to stockholders and repayments of indebtedness, is from our hotels’ results of operations. For the nine months ended September 30, 2005, net cash provided by operating activities was $19.7 million. We currently expect that our operating cash flows will be sufficient to fund our continuing operations, including distributions to stockholders required to maintain our REIT status and our required debt service obligations.

For the nine months ended September 30, 2005, net cash used in investing activities was $128.9 million, including $107.3 million to purchase the Sheraton Annapolis hotel, the Tucancun Beach Resort and Villas, and

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the Wyndham Palm Springs hotel. In conjunction with the acquisition of the Tucancun Beach Resort and Villas, we paid $3.5 million of value-added taxes (VAT). We have filed a VAT refund request with the Mexican taxing authorities and expect to receive the cash back in the late fourth quarter 2005. We used $35.9 million in improvements and additions to our hotel properties, the majority of which was used for the major renovations taking place at seven of our hotel properties. We received a net $17.9 million from our restricted cash escrow accounts. The majority of the $17.9 million cash inflow related to reimbursements from one of our loan servicers that required us to escrow $27.5 million for renovations on the hotels that secure the lending.

For the nine months ended September 30, 2005, net cash provided by financing activities was $239.1 million. On September 28, 2005, we completed an underwritten public offering of 11,500,000 shares of common stock and 3,000,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock. After deducting underwriting fees and issuance costs, we generated net proceeds of approximately $183 million. We also generated $77.1 million in proceeds from the issuance of long-term debt in conjunction with the acquisition of the Tucancun Beach Resort and Villas and the Wyndham Palm Springs hotel. In addition, we used $17.2 million to pay dividends and distributions to common stockholders and holders of Operating Partnership units and $3.0 million to make principal payments on our long-term debt.

As of September 30, 2005, we had cash and cash equivalents of $205.5 million, restricted cash of $20.8 million, and $10 million of borrowing capacity under the term loan facility. On October 24, 2005, we acquired the 385-room Hilton Boston Back Bay hotel in Boston, Massachusetts for $110 million, plus customary closing costs. As of November 4, 2005, we had cash and cash equivalents of approximately $96 million. We intend to invest our remaining cash and cash equivalents and additional capacity under the term loan facility in hotel properties, either through planned renovations or new hotel acquisitions.

In connection with the acquisition of the Hilton Parsippany hotel, the Crowne Plaza Atlanta-Ravinia hotel, the Hyatt Regency Wind Watch Long Island hotel, and the Courtyard Boston Tremont hotel, we completed a $160 million financing, comprised of a $135 million mortgage loan and a $25 million mezzanine loan. The loan agreements contain a restrictive provision that requires the loan servicer to retain in escrow excess cash flow from the encumbered hotel properties if net cash flow, as defined, for the trailing 12 months declines below a specified threshold. For the 12 months ended September 30, 2005, net cash flow from the four hotel properties did not exceed the specified threshold. The loan servicer has the right to retain in escrow excess cash flow from the four hotel properties until the hotels generate the minimum cash flow required for three consecutive months, at which time the cash being held in escrow will be released to us. Should the loan servicer retain excess cash flows from the four hotel properties, we do not expect it to have a significant impact on our ability to continue to service debt, pay dividends to stockholders, or acquire additional hotel properties.

Capital Expenditures

We maintain each hotel in good repair and condition and in conformity with applicable laws and regulations and in accordance with the franchisor’s standards and the agreed-upon requirements in our management agreements. The cost of all such routine maintenance, repairs and alterations will be paid out of a property improvement fund, which will be funded by a portion of hotel gross revenues. Routine repairs and maintenance will be administered by the management companies. However, we have approval rights over capital expenditures.

During 2005, major renovations were completed at the following hotel properties: a guest room, restaurant, lounge and lobby renovation at the Plaza San Antonio Marriott hotel; a guest room, restaurant, lounge and lobby renovation at the Crowne Plaza Atlanta-Ravinia hotel; a guest room, junior ballroom, restaurant, lounge and lobby renovation at the Hyatt Regency Savannah hotel; and a guest room, restaurant, lounge and lobby renovation at the Hyatt Regency Wind Watch Long Island hotel. Major renovation projects at three of our hotel properties will continue during the remainder of 2005 and into 2006. These projects include: a guest room, lobby and restaurant renovation at the Courtyard Boston Tremont hotel; a guest room, lobby, restaurant and ballroom renovation at the Hilton Parsippany hotel; and a guest room, restaurant, bar and lobby renovation at the Radisson Mount Laurel hotel.

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We expect to spend approximately $60 million on the renovations at the seven hotel properties, of which approximately $35 million had been spent through September 30, 2005. For the three and nine months ended September 30, 2005, we spent approximately $7 million and $30.5 million, respectively, on the renovations. We expect that the majority of the remaining cash will be committed or spent by the end of the first quarter 2006.

Contractual Obligations

The following table sets forth our contractual obligations as of September 30, 2005, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands). There were no other material off-balance sheet arrangements at September 30, 2005.

	Payments Due by Period
Contractual Obligations	Total		Less Than One Year		One to Three Years		Three to Five Years		More Than Five Years
Ground and building leases(1)	$	70,585	$	1,390	$	2,748	$	2,648	$	63,799
Mortgage loans, including interest		410,510		23,449		47,486		55,543		284,032
Mezzanine loan, including interest		36,768		2,411		4,822		4,822		24,713
Term loan facility, including interest(2)		103,359		5,932		97,427		—		—
	$	621,222	$	33,182	$	152,483	$	63,013	$	372,544

(1) Included in the table are the base rent payments (i.e., minimum lease payments) due under the ground and building lease agreements for the Portsmouth Renaissance hotel and adjoining conference center and the conference center and parking facility adjoining the Sugar Land Marriott hotel. The lease agreements provide for base rent payments each year and additional rent payments once we have exceeded a specified return on our original investment. Additional rent payments are not included in the table due to the uncertainty of the timing and amount of the payments in the future. However, we do not expect to make additional rent payments over the next five years.

(2) Assumes no additional borrowings under the term loan facility and interest payments based on the interest rate in effect as of September 30, 2005.

Inflation

Operators of hotels, in general, possess the ability to adjust room rates daily to reflect the effects of inflation. However, competitive pressures may limit the ability of our management companies to raise room rates.

Seasonality

Demand in the lodging industry is affected by recurring seasonal patterns. For non-resort properties, demand is generally lower in the winter months due to decreased travel and higher in the spring and summer months during the peak travel season. For resort properties, such as the Barceló Tucancun Beach resort, demand is generally higher in the winter months. We expect that our operations will generally reflect non-resort seasonality patterns. Accordingly, we expect that we will have lower revenue, operating income and cash flow in the first and fourth quarters and higher revenue, operating income and cash flow in the second and third quarters. These general trends are, however, expected to be greatly influenced by overall economic cycles.

Critical Accounting Policies

We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our financial statements:

Investment in Hotel Properties—Investments in hotel properties are stated at acquisition cost and allocated to land, property and equipment and identifiable intangible assets at fair value in accordance with Statement of

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Financial Accounting Standards No. 141,Business Combinations. Property and equipment are recorded at fair value based on current replacement cost for similar capacity and allocated to buildings, improvements, furniture, fixtures and equipment using cost segregation studies performed by management and independent third parties. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15 to 40 years for buildings and improvements and three to ten years for furniture and equipment. Identifiable intangible assets are typically contracts, including lease, management and franchise agreements, which are recorded at fair value. Above-market and below-market contract values are based on the present value of the difference between contractual amounts to be paid pursuant to the contracts acquired and our estimate of the fair market contract rates for corresponding contracts measured over a period equal to the remaining non-cancelable term of the contract. Contracts acquired which are at market do not have significant value. An existing management or franchise agreement is typically terminated at the time of acquisition and a new agreement is entered into based on then current market terms. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired.

We review our investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the investments in 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 operations and the proceeds from the ultimate disposition of an investment in a hotel property exceed the hotel’s 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 estimated fair market value is recorded and an impairment loss recognized.

Stock-Based Compensation—We account for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation. For restricted stock awards, we record unearned compensation equal to the number of shares awarded multiplied by the average price of our common stock on the date of the award, less the purchase price for the stock, if any. Unearned compensation is amortized using the straight-line method over the vesting period. For unrestricted stock awards, we record compensation expense on the date of the award equal to the number of shares awarded multiplied by the closing price of our common stock on the date of the award, less the purchase price for the stock, if any.

Revenue Recognition—Hotel revenues, including room, food and beverage, and other hotel revenues, are recognized as the related services are provided.

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 lessees, we have not recorded a valuation allowance to reduce our net deferred tax asset as of September 30, 2005. 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.

New Accounting Pronouncements

Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment(“SFAS 123R”), requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That

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cost will be recognized over the period during which an employee is required to provide service in exchange for the award. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. The provisions of SFAS 123R will be effective as of January 1, 2006. Since we currently use the fair value method of accounting for stock-based compensation, the adoption of SFAS 123R is not expected to have a material effect on our results of operations, financial position, or cash flows.

Forward-Looking Statements

This report contains 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 and the lodging industry 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.

These risks and uncertainties, together with the information contained in our Form 8-K filed with the Securities and Exchange Commission on March 15, 2005 under the caption “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

Interest Rate Risk—We are not significantly exposed to interest rate risk. As of September 30, 2005, $315.9 million or 76% of our $417.2 million of long-term debt was fixed. Another $11.3 million was effectively fixed, as a result of an interest rate swap that fixes the interest rate on one of our mortgage loans at 7.34%. The remaining $90 million of our long-term debt was variable.

Due to the fact that our portfolio of long-term debt is substantially comprised of fixed-rate instruments, the fair value of the portfolio is relatively sensitive to effects of interest rate fluctuations. Assuming a hypothetical

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10% decrease in interest rates, the fair value of our portfolio of long-term debt would increase by approximately $9.6 million. Although a change in market interest rates impacts the fair value of our fixed-rate debt, it has no impact on interest expense incurred or cash flows.

With respect to our variable rate long-term debt, if market rates of interest on our variable long-term debt increase by 1%, the increase in interest expense on our variable long-term debt would decrease future earnings and cash flows by approximately $0.9 million annually. On the other hand, if market rates of interest on our variable rate long-term debt decrease by 1%, the decrease in interest expense on our variable rate long-term debt would increase future earnings and cash flows by approximately $0.9 million annually. This assumes that the amount outstanding under our term loan facility remains at $90 million, the balance at September 30, 2005.

Foreign Currency Risk—We are not significantly exposed to foreign currency risk. The majority of revenue from operations at the Barceló Tucancun Beach resort are denominated in U.S. dollars and the majority of operating expenses are denominated in Mexican pesos. A hypothetical 10% change in the exchange rate between the U.S. dollar and the Mexican peso would not have a material affect on our results of operations.

Item 4. Controls and Procedures

The Chief Executive Officer and Chief Financial Officer of Highland 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, Highland Hospitality Corporation’s disclosure controls and procedures were effective.

There was no change in Highland 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 Highland Hospitality Corporation’s most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, Highland Hospitality Corporation’s internal control over financial reporting.

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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 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits

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

Exhibit Number	Description of Exhibit
3.1	Amended and Restated Articles of Incorporation of Highland Hospitality Corporation (incorporated by reference to Exhibit 3.1 to the registrant’s Form 10-K for the year ended December 31, 2003)
3.2	Amended and Restated Bylaws of Highland Hospitality Corporation (incorporated by reference to Exhibit 3.2 to the registrant’s Form 10-K for the year ended December 31, 2003)
3.3	Third Amendment to the Second Amended and Restated Agreement of Limited Partnership of Highland Hospitality, L.P.
4.1	Articles Supplementary to Highland Hospitality Corporation’s Articles of Amendment and Restatement relating to the 7.875% Series A Cumulative Redeemable Preferred Stock (incorporated by reference to Exhibit 4.1 to the registrant’s Form 8-K dated September 27, 2005)
4.2	Form of Certificate for 7.875% Series A Cumulative Redeemable Preferred Stock (incorporated by reference to Exhibit 4.2 to the registrant’s Form 8-K dated September 27, 2005)
10.1	Leasehold Deed of Trust and Security Agreement, dated July 14, 2005, between HH Palm Springs LLC and Connecticut General Life Insurance Company
12.1	Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends
31.1	Rule 13a-14(a)/15d-14(a) Certification of President and Chief Executive Officer
31.2	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1	Section 1350 Certification of President and Chief Executive Officer
32.2	Section 1350 Certification of Chief Financial Officer

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SIGNATURE

Pursuant to the requirements 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.

	HIGHLAND HOSPITALITY CORPORATION
Date: November 8, 2005	By:	/s/    DOUGLAS W. VICARI
		Douglas W. Vicari
		Executive Vice President, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

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