Sotherly Hotels (SOHO) 10-Q 2006 Q2 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 June 30, 2006

OR

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

For the transition period from            to            .

Commission file number 001-32379

MHI HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

MARYLAND	20-1531029
(State or Other Jurisdiction of corporation or Organization)	(I.R.S. Employer Identification No.)

814 Capitol Landing Road, Williamsburg, Virginia 23185

Telephone Number (757) 229-5648

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).

Large Accelerated Filer  ¨    Accelerated Filer  ¨    Non-accelerated Filer  x

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

As of August 8, 2006, there were 6,712,000 shares of the registrant’s common stock issued and outstanding.

MHI HOSPITALITY CORPORATION

INDEX

		Page
	PART I
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23
Item 4.	Controls and Procedures	24
	PART II
Item 1.	Legal Proceedings	25
Item 1A.	Risk Factors	25
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3.	Defaults Upon Senior Securities	25
Item 4.	Submission of Matters to a Vote of Security Holders	25
Item 5.	Other Information	25
Item 6.	Exhibits	26

2

PART I

Item 1.Financial Statements

MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

	June 30, 2006			December 31, 2005
	(unaudited)
ASSETS
Investment in hotel properties, net	$	102,395,115		$	101,583,250
Cash and cash equivalents		2,420,555			501,810
Restricted cash		3,464,106			4,330,981
Accounts receivable		2,634,505			2,095,193
Accounts receivable-affiliate		4,463			242,362
Prepaid expenses, inventory and other assets		2,419,960			1,917,038
Assets held for sale		4,506,364			4,451,912
Shell Island lease purchase, net		2,832,279			3,088,235
Deferred financing costs, net		683,717			175,142
TOTAL ASSETS	$	121,361,064		$	118,385,923
LIABILITIES
Line of credit	$	7,678,232		$	3,500,000
Mortgage loans		42,157,632			42,686,943
Accounts payable and accrued expenses		5,520,253			5,106,882
Dividends and distributions payable		1,801,661			1,803,973
Advance deposits		648,177			266,657
TOTAL LIABILITIES		57,805,955			53,364,455
Minority interest in operating partnership		21,217,912			21,805,572
Commitments and contingencies (see Note 7)
SHAREHOLDERS’ EQUITY
Preferred stock, par value $0.01, 1,000,000 shares authorized, 0 shares issued and outstanding		—			—
Common stock, par value $0.01, 49,000,000 shares authorized, 6,712,000 shares issued and outstanding at June 30, 2006 and December 31, 2005		67,120			67,040
Additional paid in capital		47,890,267			47,760,347
Accumulated deficit		(5,620,190	)		(4,611,491	)
TOTAL SHAREHOLDERS’ EQUITY		42,337,197			43,215,896
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	121,361,064		$	118,385,923

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

3

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three months ended June 30, 2006			Three months ended June 30, 2005			Six months ended June 30, 2006			Six months ended June 30, 2005
REVENUE
Rooms department	$	12,379,692		$	9,472,674		$	22,804,541		$	16,856,963
Food and beverage department		5,353,338			4,224,297			9,585,311			7,427,867
Other operating departments		868,059			610,782			1,738,809			1,108,110
Total revenue		18,601,089			14,307,753			34,128,661			25,392,940
EXPENSES
Hotel operating expenses
Rooms department		3,381,090			2,403,631			6,275,188			4,566,744
Food and beverage department		3,485,574			2,689,409			6,574,175			5,035,024
Other operating departments		223,168			180,385			435,759			325,764
Indirect		6,530,643			4,851,936			12,611,506			9,363,692
Total hotel operating expenses		13,620,475			10,125,361			25,896,628			19,291,224
Depreciation and amortization		1,221,820			1,057,876			2,388,255			1,840,912
Corporate general and administrative		663,970			497,017			1,454,415			965,167
Total operating expenses		15,506,265			11,680,254			29,739,298			22,097,303
NET OPERATING INCOME		3,094,824			2,627,499			4,389,363			3,295,637
Other income (expense)
Interest expense		(1,095,832	)		(422,213	)		(2,069,946	)		(1,035,610	)
Interest income		21,464			53,346			43,411			101,658
Net income before minority interest in operating partnership and income taxes		2,020,456			2,258,632			2,362,828			2,361,685
Minority interest in operating partnership		(642,125	)		(784,055	)		(779,204	)		(809,101	)
Income tax provision		(276,483	)		(148,064	)		(246,603	)		(148,064	)
Income from continuing operations		1,101,848			1,326,513			1,337,021			1,404,520
Income (loss) from discontinued operations, net		25,945			62,554			(65,680	)		(43,916	)
NET INCOME	$	1,127,793		$	1,389,067		$	1,271,341		$	1,360,604
Continued operations per share
Basic	$	0.16		$	0.20		$	0.20		$	0.21
Diluted	$	0.16		$	0.20		$	0.20		$	0.21
Discontinued operations per share
Basic	$	0.00		$	0.01		$	(0.01	)	$	(0.00	)
Diluted	$	0.00		$	0.01		$	(0.01	)	$	(0.00	)
Net income (loss) per share
Basic	$	0.16		$	0.21		$	0.19		$	0.21
Diluted	$	0.16		$	0.21		$	0.19		$	0.21
Weighted average number of shares outstanding
Basic		6,705,978			6,704,000			6,704,994			6,630,519
Diluted		6,774,978			6,704,000			6,770,464			6,630,519

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

4

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(unaudited)

	Common Stock			Additional Paid-In Capital		Accumulated Deficit			Total
	Shares	Par Value
Balances at December 31, 2005	6,704,000	$	67,040	$	47,760,347	$	(4,611,491	)	$	43,215,896
Issuance of restricted common stock awards	8,000		80		72,920		—			73,000
Amortization of deferred stock grants					57,000		—			57,000
Net income					—		1,271,341			1,271,341
Dividends declared					—		(2,280,040	)		(2,280,040	)
Balances at June 30, 2006	6,712,000	$	67,120	$	47,890,267	$	(5,620,190	)	$	42,337,197

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

5

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	Six months Ended June 30, 2006			Six months ended June 30, 2005
Cash Flows from Operating Activities:
Net income	$	1,271,341		$	1,360,604
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,523,096			1,951,906
Amortization of deferred financing costs		114,178			38,788
Charges related to equity-based compensation		130,000			—
Minority interest in operating partnership		740,926			783,818
Changes in assets and liabilities:
Restricted cash		(347,454	)		(425,458	)
Accounts receivable		(539,313	)		(1,106,831	)
Inventory, prepaid expenses and other assets		(473,167	)		(982,036	)
Accounts payable and accrued expenses		413,369			(1,077,052	)
Advance deposits		381,520			151,023
Due from affiliates		237,899			257,465
Net cash provided by operating activities		4,452,395			952,227
Cash flows from investing activities:
Improvements and additions to hotel properties		(3,163,212	)		(3,477,517	)
Proceeds of restricted capital improvement reserve		1,214,330			—
Net cash used in investing activities		(1,948,882	)		(3,477,517	)
Cash flows from financing activities:
Proceeds from sale of common stock		—			7,000,000
Payment of issuance costs related to sale of common stock		—			(490,000	)
Dividends and distributions paid		(3,610,938	)		(1,786,905	)
Proceeds from line of credit		4,178,232			—
Payments on related party note		—			(2,000,000	)
Payment of deferred financing costs		(622,751	)		(54,565	)
Payment of loans		(529,311	)		(557,337	)
Net cash provided by (used in) financing activities		(584,768	)		2,111,193
Net increase (decrease) in cash and cash equivalents		1,918,745			(414,097	)
Cash and cash equivalents at the beginning of the period		501,810			8,314,353
Cash and cash equivalents at the end of the period	$	2,420,555		$	7,900,256
Supplemental disclosures:
Cash paid during the period for interest	$	1,983,700		$	1,000,143

The accompanying notes are an integral part of these financial statements

6

MHI HOSPITALITY CORPORATION

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Organization and Description of Business

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

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

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

On June 20, 2006, the Company announced it had entered into a definitive agreement to sell the Holiday Inn Downtown, in Williamsburg, VA for $4.75 million. The Company has agreed to take back three promissory notes that total $4.43 million from the purchaser and will receive the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007. The third promissory note in the amount of $0.4 million with interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. The Company has committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes will be secured by a security interest in the hotel and by personal guarantees of affiliates of the purchaser. The closing is subject to customary terms and conditions.

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

2. Summary of Significant Accounting Policies

Basis of Presentation –The consolidated financial statements of the Company presented herein include all of the accounts of MHI Hospitality Corporation as of and for the three months and six months ended June 30, 2006 and 2005.

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

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

7

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

Fair Value of Financial Instruments –The Company’s financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, and mortgage loans. Due to their short maturities, or in the case of mortgage loans, interest rates in line with current interest rates, these financial instruments are carried at amounts that reasonably approximate fair value.

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

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

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

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

Franchise License Fees –Fees expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The unamortized franchise fees as of June 30, 2006 and December 31, 2005 were $197,120 and $208,308, respectively. Amortization expense totaled $7,513 and $14,592 for the three months and six months ended June 30, 2006 and $5,625 and $11,250 for the three and six months ended June 30, 2005, respectively.

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

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

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

8

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 MHI Hospitality TRS, LLC, the Company’s wholly owned taxable REIT subsidiary. MHI Hospitality TRS, LLC, which leases the Company’s hotels from the Operating Partnership, is subject to federal and state income taxes.

The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109,Accounting for Income Taxes(“SFAS 109”). Under SFAS 109, the Company accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.

Stock-based Compensation – The Company’s 2004 Long Term Incentive Plan (“Plan”) permits the grant of stock options, restricted (non-vested) stock and performance share compensation awards to its employees for up to 350,000 shares of common stock. The Company believes that such awards better align the interest of its employees with those of its shareholders.

Under the Plan, the Company has made restricted stock and deferred stock awards totaling 81,000 shares including 69,000 shares granted under deferred stock awards to its executives, 4,000 restricted shares issued to certain employees, and 8,000 restricted shares issued to its directors. Of the 69,000 shares granted under deferred stock awards, 60,000 shares vest over five years and 9,000 shares vest at the end of this year. Regarding the restricted shares awarded the Company’s directors and certain employees; the shares vest immediately and represent compensation for the previous year of service. All such shares are charged to compensation expense on a straight-line basis over the vesting or service period based on the Company’s stock price on the date of grant or issuance. Under the Plan, the Company may issue a variety of performance-based stock awards, including nonqualified stock options. As of June 30, 2006, no performance-based stock awards have been issued. Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value method. Total compensation cost recognized under the Plan was $28,500 and $57,000 for the three months and six months ended June 30, 2006, respectively and $0 for the three months and six months ended June 30, 2005.

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

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

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

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

3. Acquisition of Hotel Properties

There were no new acquisitions in the six months ended June 30, 2006.

4. Investment in Hotel Properties

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

	MHI Hospitality Corporation June 30, 2006			MHI Hospitality Corporation December 31, 2005
	(unaudited)
Land and land improvements	$	12,530		$	12,513
Buildings and improvements		86,764			86,399
Furniture, fixtures and equipment		22,226			19,629
		121,520			118,541
Less: accumulated depreciation		(19,125	)		(16,958	)
	$	102,395		$	101,583

9

5. Credit Facility

As of June 30, 2006, the Company had a secured, revolving credit facility with a financial institution that enabled the Company to borrow up to $60 million, subject to borrowing base and loan-to-value limitations, with a syndicated bank group comprising of Branch Banking & Trust Company (BB&T), Key Bank National Association, Regions Bank and Manufacturers and Traders Trust Company. The credit facility was refinanced during second quarter of 2006 and replaced a $23 million secured, revolving credit facility with BB&T. The Company had borrowings of $7,678,232 and $3,500,000 at June 30, 2006 and December 31, 2005, respectively.

The facility matures during May 2010 and bears interest at a floating rate of LIBOR plus additional interest ranging from 2.0% to 2.5%. On June 30, 2006, LIBOR was 5.334%. In some circumstances, the revolving line of credit facility may bear interest at BB&T’s prime rate. Any amounts drawn under the revolving line of credit facility mature at the expiration of the facility. The revolving line of credit facility includes an uncommitted accordion facility, pursuant to which the Company may be able to increase the total commitment under the revolving line of credit facility up to $75 million. The Company is required to pay a fee of 0.25% on the unused portion of the credit facility. Under the terms of the agreement, the Company is required to enter into an interest rate swap in order to hedge against interest rate risk.

The facility is secured by the Holiday Inn Brownstone and the Hilton Philadelphia Airport, and a lien on all business assets of those properties including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. The two properties had a net carrying value of approximately $35.6 million. Under the terms of the BB&T line of credit, the Company must satisfy certain financial and non-financial covenants. As of June 30, 2006 and December 31, 2005, the Company was in compliance with all of the required covenants.

6. Mortgage Debt

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

On September 25, 1998, Savannah Hotel Associates, LLC obtained a mortgage loan in the amount of $12.8 million to refinance the mortgage at the Savannah DeSoto Hilton hotel. The loan is secured by the Savannah DeSoto Hilton hotel and its maturity date is November 1, 2008. Loan principal and interest payments are due monthly, with fixed principal payments plus interest amortized over a twenty (20) year schedule. Interest is based on a fixed rate of 7.49%. Savannah Hotel Associates, LLC recorded deferred financing costs of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the loan as of June 30, 2006 and December 31, 2005 was $9,935,121 and $10,175,989, respectively.

On February 12, 1998 Capitol Hotel Associates, LP, LLP obtained a mortgage loan in the amount of $13.0 million to refinance the mortgage at the Wilmington Riverside Hilton hotel. On October 19, 1999 Capitol Hotel Associates, LP, LLP obtained a promissory note in the amount of $4.25 million upon completion of construction of renovations. The debt was consolidated into one instrument and is secured by the Wilmington Riverside Hilton hotel and its maturity date is March 1, 2008. Loan principal and interest payments are due monthly, with fixed principal payments and interest payments amortized over a twenty (20) year schedule. Interest is based on a fixed rate of 8.22%. Capitol Hotel Associates, LP, LLP recorded deferred financing costs of approximately $0.2 million related to obtaining the mortgage loan. The outstanding balance due on the loan as of June 30, 2006 and December 31, 2005 was $14,222,512 and $14,510,954, respectively.

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

Total debt maturities as of June 30, 2006 were as follows ($000s):

2006	$	552
2007		1,168
2008		22,439
2009		—
2010		18,000
Total	$	42,158

10

7. Commitments and Contingencies

Ground, Building and Submerged Land Leases – The Company leases 2,086 square feet of commercial space next to the Savannah hotel property for use as an office, retail or conference space, or for any related or ancillary purposes for the hotel and/or atrium space. The space is leased under a six-year operating lease, which expires October 31, 2006. There is a renewal option for up to three five-year periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for this operating lease was $10,795 and $21,590 for the three months and six months ended June 30, 2006, respectively and $9,387 and $18,774 for the three months and six months ended June 30, 2005, respectively.

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

The Company leases a parking lot adjacent to the Holiday Inn Brownstone in Raleigh, North Carolina. The land is leased under a second amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a 50-year operating lease, which expires August 31, 2016. There is a renewal option for up to three additional ten-year periods expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. The Company holds an exclusive and irrevocable option to purchase the leased land at fair market value at the end of the original lease term, subject to the payment of an annual fee of $9,000, and other conditions. Rent expense for this operating lease is $76,104 annually, and is expected to remain the same in 2006. For the three months ended June 30, 2006 and 2005, rent expense was $19,026. For the six months ended June 30, 2006 and 2005, rent expense was $38,052.

In conjunction with the sublease arrangement for the property at Shell Island, the Company incurs an annual lease expense for a leasehold interest other than the purchased leasehold interest. Lease expense was $40,238 and $80,213 for the three months and six months ended June 30, 2006 and $42,764 and $84,528 for the three months and six months ended June 30, 2005, respectively.

The Company leases certain submerged land in the Saint Johns River in front of the Crowne Plaza Jacksonville Hotel from the Board of Trustees of the Internal Improvement Trust Fund of the State of Florida. The submerged land is leased under a five-year operating lease, which expires September 18, 2007. Rent expense for the three months and six months ended June 30, 2006 was $1,160 and $2,320, respectively.

Purchase Agreement – On September 13, 2005, the Company entered into an agreement to purchase the commercial space of a property in Hollywood, Florida last operated as the Ambassador Resort for $0.5 million. The developer of the property is completing a condominium conversion after which time the Company will retain MHI Hotels Services to operate the hotel. Closing is contingent on a variety of factors including the Company’s ability to secure a franchise for the hotel.

Management Agreement – Each of the seven hotels that the Company owned at June 30, 2006 operate under a ten-year master management agreement with MHI Hotels Services which expires in December 2014 for the six initial hotels and in July 2015 for the Crowne Plaza Jacksonville Hotel (see Note 9).

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

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

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

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8. Capital Stock

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

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

Warrants –The Company has granted no warrants representing the right to purchase common stock.

Preferred Shares – The Company is authorized to issue 1,000,000 shares of preferred stock, $.01 par value per share. As of June 30, 2006, there were no shares of preferred stock outstanding.

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

9. Related Party Transactions

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

Accounts Receivable –At June 30, 2006 and December 31, 2005, the Company was due $4,463 and $242,362, respectively, from MHI Hotels Services.

Shell Island Sublease – The Company has a sublease arrangement with MHI Hotels Services on its leasehold interests in the property at Shell Island. For the three months ended June 30, 2006 and 2005, the Company earned $160,000 in leasehold revenue. For the six months ended June 30, 2006 and 2005, the Company earned $320,000 in leasehold revenue.

Sublease of Office Space –The Company subleases office space in Greenbelt, MD from MHI Hotels Services. Rent expense was $9,270 and $18,540 for the three months and six months ended June 30, 2006, respectively and $11,930 and $6,375 for the three months and six months ended June 30, 2005, respectively.

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

Management Agreements –Each of the seven hotels that the Company owned at June 30, 2006 are operated by MHI Hotels Services under a master management agreement which expires in December 2014 for the six initial hotels and in July 2015 for the Crowne Plaza Jacksonville Hotel. MHI Hotels Services receives a base management fee, and if the hotels meet and exceed certain thresholds, an additional incentive management fee. The base management fee for the initial portfolio of six hotels was 2.0% in 2005, rising to 2.5% in 2006 and 3.0% thereafter of total gross revenues from the hotels. The base management fee for the Crowne Plaza Jacksonville Hotel is 2.0% through 2006, rising to 2.5% in 2007 and 3.0% thereafter. The incentive management fee, if any, will be due annually in arrears within 90 days of the end of the fiscal year and will be equal to 10% of the amount by which the gross operating profit of the hotels, on an aggregate basis, for a given year exceeds the gross operating profit for the same hotels, on an aggregate basis, for the prior year. The incentive management fee may not exceed 0.25% of gross revenues of all of the hotels included in the incentive fee calculation. Due to the uncertainty related to the calculation of the incentive management fees, the Company has not accrued any related expense related to these fees as of June 30, 2006.

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The Company paid MHI Hotels Services approximately $0.469 million and $0.844 million for the three months and six months ended June 30, 2006, respectively, and approximately $0.227 million and $0.527 million for the three months and six months ended June 30, 2005, respectively, in management fees.

Employee Medical Benefits –The Company purchases employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. The Company paid $18,708 and $36,093 for the three months and six months ended June 30, 2006, respectively and $7,125 and $14,250 for the three months and six months ended June 30, 2005, respectively for benefits.

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

Construction Management Services – The Company engaged MHI Hotels Services to manage the renovation of the Crowne Plaza Jacksonville. For the three months and six months ended June 30, 2006, the company paid $112,000 in construction management fees.

10. Income Taxes

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

	Three Months Ended June 30, 2006			Three Months Ended June 30, 2005			Six Months Ended June 30, 2006			Six Months Ended June 30, 2005
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Current:
Federal	$	—		$	—		$	—		$	—
State		28			51			286			51
		28			51			286			51
Deferred:
Federal		250			55			(104	)		55
State		(1	)		(53	)		(29	)		(53	)
		249			2			(133	)		2
	$	277		$	53		$	153		$	53

A reconciliation of the statutory federal income tax expense to the Company’s income tax provision is as follows (in thousands):

	Three Months Ended June 30, 2006			Three Months Ended June 30, 2005			Six Months Ended June 30, 2006			Six Months Ended June 30, 2005
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Statutory federal income tax expense	$	687		$	769		$	803		$	747
Effect of non-taxable REIT income		(437	)		(714	)		(907	)		(692	)
State income tax expense		27			(2	)		257			(2	)
	$	277		$	53		$	153		$	53

As of June 30, 2006, the Company had a net deferred tax asset of approximately $0.84 million, primarily due to past years’ net operating loss. These loss carryforwards will begin to expire in 2024 if not utilized by then. The Company believes that is more likely than not that the deferred tax asset will be realized and that no valuation allowance is required.

11. Discontinued Operations

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

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

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

	Three months ended June 30, 2006			Three months ended June 30, 2005			Six months ended June 30, 2006			Six months ended June 30, 2005
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Revenue
Rooms department	$	664,717		$	666,837		$	869,020		$	938,131
Food and beverage department		241,084			252,655			359,683			371,820
Other operating departments		13,481			15,744			18,111			22,944
Total revenue		919,282			935,236			1,246,814			1,332,895
Expenses
Hotel operating expenses
Rooms department		249,564			205,932			362,653			316,129
Food and beverage department		211,557			223,043			348,657			350,299
Other operating departments		12,126			10,468			19,188			21,942
Indirect		334,190			432,199			579,255			698,077
Total hotel operating expenses		807,437			871,642			1,309,753			1,386,447
Depreciation and amortization		69,939			59,685			134,841			110,994
Total operating expenses		877,376			931,327			1,444,594			1,497,441
Net operating income		41,906			3,909			(197,780	)		(164,546	)
Minority interest in operating partnership		(15,129	)		(36,705	)		38,278			25,281
Income tax (provision) benefit		(832	)		95,349			93,822			95,349
Net income from discontinued operations	$	25,945		$	62,553		$	(65,680	)	$	(43,916	)

12. Earnings per Share

	Three months ended June 30, 2006		Three months ended June 30, 2005		Six months ended June 30, 2006		Six months ended June 30, 2005
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Net income	$	1,127,793	$	1,389,067	$	1,271,341	$	1,360,604
Basic:
Weighted average number of common shares outstanding		6,705,978		6,704,000		6,704,994		6,630,519
Net income per share - basic	$	0.16	$	0.20	$	0.19	$	0.21
Diluted:
Dilutive awards		69,000		—		65,470		—
Diluted weighted average number common shares outstanding		6,774,978		6,704,000		6,770,464		6,630,519
Net income per share - diluted	$	0.16	$	0.20	$	0.19	$	0.21

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

13. Subsequent Events

On July 6, 2006, the Company announced that it entered into a definitive agreement to purchase the 186-room Louisville Ramada Riverfront Inn, located in Jeffersonville, Indiana for $7.6 million. The hotel is located directly on the Ohio River, with unimpeded views of the Louisville skyline, and easy access to the center of downtown Louisville. The Company intends to extensively renovate and re-brand the hotel, as is consistent with the company’s repositioning strategy. To facilitate the closing of the acquisition, which is expected in the late third quarter subject to customary closing conditions, the Company may access funds from either its line of credit or the proceeds of the sale of the Holiday Inn Downtown Williamsburg, VA, or a combination of the two.

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On July 11, 2006, the Company paid the dividend for the second quarter of 2006 that was authorized on April 24, 2006 to those stockholders and unit holders of MHI Hospitality, L.P. of record on June 15, 2006. The dividend was $0.17 per share (unit).

On July 17, 2006, the Company authorized the payment of a quarterly dividend of $0.17 per share (unit) to the stockholders and unit holders of record as of September 15, 2006. The dividend is to be paid October 11, 2006.

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

Overview

We are a self-advised REIT incorporated in Maryland in August 2004 to pursue current and future opportunities in the full-service, upper upscale, upscale and mid-scale segments of the hotel industry. We commenced operations in December 2004 when we completed our initial public offering.

Concurrent with the completion of the IPO, we acquired six hotel properties. Our hotel portfolio currently consists of seven full-service, upper upscale and mid-scale hotels. The seventh hotel, the Crowne Plaza Jacksonville Hotel (formerly, the Hilton Jacksonville Riverfront Hotel), was acquired on July 22, 2005. We own a 100% interest in all of our hotels. We also have a leasehold interest in a resort condominium facility. As of June 30, 2006, we owned the following hotel properties:

Property	Number of Rooms	Location	Date of Acquisition
Hilton Philadelphia Airport	331	Philadelphia, PA	December 21, 2004
Holiday Inn Laurel West	207	Laurel, MD	December 21, 2004
Holiday Inn Downtown Williamsburg	136	Williamsburg, VA	December 21, 2004
Holiday Inn Brownstone	187	Raleigh, NC	December 21, 2004
Hilton Wilmington Riverside	274	Wilmington, NC	December 21, 2004
Hilton Savannah DeSoto	246	Savannah, GA	December 21, 2004
Crowne Plaza Jacksonville	292	Jacksonville, FL	July 22, 2005
Total	1,673

On June 15, 2006, we entered into a definitive agreement to sell the Holiday Inn Downtown, in Williamsburg, VA for $4.75 million. We agreed to take back three promissory notes totaling $4.43 million from the purchaser and will receive the remainder of the purchase price in cash. Promissory notes in the amount of $2.63 million and $1.4 million will mature on December 31, 2006 with interest-only payments due monthly bearing rates of 8.0% and 8.5%, respectively. The notes may be extended an additional seven months to August 31, 2007. The third note in the amount of $0.4 million with interest-only payments due monthly at a rate of 8.0% will mature on August 31, 2007. We have committed to substitute the third promissory note for a $0.4 million 20-year promissory note bearing interest at 8.0% with interest-only payments due monthly for the first four years and payments under a 20-year amortization schedule thereafter if the purchaser refinances the first two promissory notes. The promissory notes will be secured by a security interest in the hotel and by personal guarantees of affiliates of the purchaser. The closing is subject to customary terms and conditions.We conduct substantially all our business through our operating partnership, MHI Hospitality, L.P. We are the sole general partner of our operating partnership and we own an approximate 63.2% interest in our operating partnership, with the remaining interest being held by the contributors of our initial properties as limited partners.

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

Key Operating Metrics

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

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

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

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

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Results of Operations

The following table illustrates the key operating metrics for the three months and six months ended June 30, 2006 and 2005 for the properties owned by the Company during the respective reporting periods. Accordingly, the operations of the Crowne Plaza Jacksonville Hotel are not reflected for the three months and six months ended June 30, 2005.

	Three months ended June 30, 2006			Three months ended June 30, 2005			Six months ended June 30, 2006			Six months ended June 30, 2005
Occupancy %		76.3	%		75.7	%		70.6	%		71.3	%
ADR	$	112.32		$	106.52		$	110.69		$	99.85
RevPAR	$	85.68		$	80.68		$	78.18		$	71.19
Available Room Nights		152,243			125,671			302,813			249,961

In addition, the table below illustrates the same metrics as they pertain to all seven properties in our current portfolio for both periods. The 2005 figures reflect the performance of the Crowne Plaza Jacksonville under previous ownership. That hotel was managed by MHI Hotels Services throughout 2005.

	Three months ended June 30, 2006			Three months ended June 30, 2005			Six months ended June 30, 2006			Six months ended June 30, 2005
Occupancy %		76.3	%		75.6	%		70.6	%		72.2	%
ADR	$	112.32		$	106.26		$	110.69		$	102.64
RevPAR	$	85.68		$	80.32		$	78.18		$	74.07
Available Room Nights		152,243			152,243			302,813			302,813

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

Revenue. Total revenue for the three months ended June 30, 2006 was approximately $18.6 million, an increase of approximately $4.3 million or 30.0% from the three months ended June 30, 2005. Approximately $2.8 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.2 million as a result of increases in occupancy and ADR.

Room revenues for the three months ended June 30, 2006 rose to approximately $12.4 million, an increase of approximately $2.9 million or 30.7% compared to room revenues for the three months ended June 30, 2005. Approximately $1.7 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.2 million or 12.2%. A new mix of business, a strong market, and the completion of room renovations caused a significant increase in ADR at our Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also contributed to the significant increase in ADR at that property.

Overall, our seven properties were able to achieve a 6.7% increase in room revenue through a combined 0.9% increase in occupancy and a 5.7% increase in ADR over the same period last year.

Food and beverage revenues for the three months ended June 30, 2006 increased approximately $1.1 million or 26.7% to approximately $5.4 million compared to food and beverage revenues for the three months ended June 30, 2005. Approximately $0.9 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees were approximately $13.6 million, an increase of approximately $3.5 million or 34.5% for the three months ended June 30, 2006 compared to approximately $10.1 million for the three months ended June 30, 2005, of which approximately $2.4 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel, which was acquired in July 2005.

Rooms expense for the three months ended June 30, 2006 increased approximately $1.0 million or 40.7% to approximately $3.4 million compared to rooms expense of approximately $2.4 million for the three months ended June 30,

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2005. Approximately $0.6 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Much of the remaining increase relates to increased expenses at our Hilton brand properties for replacing room amenities as well as the increased cost of implementing the Hilton bedding program.

Food and beverage expenses for the three months ended June 30, 2006 increased approximately $0.8 million or 29.6% to approximately $3.5 million compared to food and beverage expense for the three months ended June 30, 2005. The higher food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the three months ended June 30, 2006 increased approximately $1.7 million or 34.6% to approximately $6.5 million compared to the three months ended June 30, 2005, of which approximately $1.2 million was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Some of the indirect expenses vary directly with increases in revenue. Accordingly, we saw significant increases in sales and marketing expenses, hotel franchising fees and management fees.

Depreciation and amortization. Depreciation and amortization expense for the three months ended June 30, 2006 was approximately $1.2 million, an increase of approximately $0.2 million or 15.5% compared to approximately $1.0 million for the three months ended June 30, 2005. The increase in depreciation and amortization was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended June 30, 2006 increased approximately $0.2 million or 33.6% compared to approximately $0.7 million for the three months ended June 30, 2005. Increased staffing levels including the hiring of our Chief Operating Officer in January 2006 and our Chief Accounting Officer in May 2005 contributed to the increase.

Interest Expense. Interest expense for the three months ended June 30, 2006 increased approximately $0.7 million or 159.5% to approximately $1.1 million compared to interest expense for the thee months ended June 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of credit.

Income Tax Provision. The net income tax provision for the three months ended June 30, 2006 increased to approximately $0.3 million. The income tax provision is primarily derived from the taxable income of our TRS lessee. The taxable income of our TRS lessee attributable to continuing operations for the three months ended June 30, 2006 was greater than the taxable income attributable to continuing operations for the three months ended June 30, 2005.

Net income. The net income for the three months ended June 30, 2006 decreased approximately $0.3 million compared to the three months ended June 30, 2005 as a result of the operating results discussed above.

Comparison of Six Months Ended June 30, 2006 to Six Months Ended June 30, 2005

Revenue. Total revenue for the six months ended June 30, 2006 was approximately $34.1 million, an increase of approximately $8.7 million or 34.4% from the six months ended June 30, 2005. The increase was primarily due to approximately $6.4 million in incremental revenues attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Revenues increased due to increases in both room revenue and food and beverage revenues. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increased approximately $1.8 million as a result of an increase in ADR.

Room revenues for the six months ended June 30, 2006 rose to approximately $22.8 million, an increase of approximately $6.0 million or 35.3% compared to room revenues for the six months ended June 30, 2005. Approximately $4.2 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel. Room revenues at our other properties (with the exception of the Holiday Inn Downtown in Williamsburg, Virginia which is not included in the presentation of continuing operations) increase approximately $1.8 million or 10.6%. A new mix of business, a strong market, and the completion of room renovations caused a significant increase in ADR at our Philadelphia property. Our efforts to re-position our property in Laurel, Maryland coupled with the completion of renovations also contributed to the significant increase in ADR at that property.

Overall, our seven properties were able to achieve a 5.6% increase in revenue despite a 2.1% decline in occupancy by achieving a 7.9% increase in ADR over the same period.

Food and beverage revenues for the six months ended June 30, 2006 increased approximately $2.2 million or 29.0% to approximately $9.6 million compared to food and beverage revenues for the six months ended June 30, 2005. Approximately $1.7 million of the increase was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses, and management fees were approximately $25.9 million, an increase of approximately $6.6 million or

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34.6% for the six months ended June 30, 2006 compared to approximately $19.3 million for the six months ended June 30, 2005, primarily due to approximately $5.2 million in incremental expense attributable to the acquisition of the Crowne Plaza Jacksonville Hotel in July 2005.

Rooms expense for the six months ended June 30, 2006 increased approximately $1.7 million or 37.4% to approximately $6.3 million compared to rooms expense of approximately $4.6 million for the six months ended June 30, 2005 primarily due to the acquisition of the Crowne Plaza Jacksonville Hotel. Much of the remaining increase relates to increased expenses at our Hilton brand properties for replacing room amenities as well as the increased cost of implementing the Hilton bedding program.

Food and beverage expenses for the six months ended June 30, 2006 increased approximately $1.5 million or 30.6% to approximately $6.6 million compared to food and beverage expense for the six months ended June 30, 2005. The higher food and beverage costs are attributable to the higher volume of food and beverage sales. Indirect expenses at our properties for the six months ended June 30, 2006 increased approximately $3.2 million or 34.7% to approximately $12.6 million compared to the six months ended June 30, 2005, primarily due to the acquisition of the Crowne Plaza Jacksonville Hotel. We saw significant increases in sales and marketing expenses, hotel franchise fees and management fees as these expenses vary directly with increases in revenue.

Depreciation and amortization. Depreciation and amortization expense for the six months ended June 30, 2006 was approximately $2.4 million, an increase of approximately $0.5 million or 29.7% compared to approximately $1.8 million for the six months ended June 30, 2005. The increase in depreciation and amortization was attributable to the acquisition of the Crowne Plaza Jacksonville Hotel as well as the renovation activities at our Philadelphia, Williamsburg and Laurel properties.

Corporate General and Administrative. Corporate general and administrative expenses for the six months ended June 30, 2006 increased approximately $0.5 million or 50.7% compared to the six months ended June 30, 2005 to approximately $1.5 million. Increased staffing levels, including the hiring of our Chief Operating Officer in January 2006 and our Chief Accounting Officer in May 2005, as well as an accelerated timetable for the preparation of the Company’s tax returns contributed to the increase.

Interest Expense. Interest expense for the six months ended June 30, 2006 increased approximately $1.0 million or 99.9% to approximately $2.1 million compared to interest expense for the same period ended June 30, 2005, primarily due to the mortgage on the Crowne Plaza Jacksonville Hotel acquired in July 2005 and borrowings on the line of credit.

Income Tax Provision. The net income tax provision for the six months ended June 30, 2006 increased to approximately $0.2 million. The income tax provison is primarily derived from the taxable income of our TRS lessee. The taxable income of our TRS lessee attributable to continuing operations for the six months ended June 30, 2006 was greater than the taxable income attributable to continuing operations for the six months ended June 30, 2005.

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

Funds From Operations

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

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

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operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.

The following table reconciles net income to FFO for the three months and six months ended June 30, 2006 and 2005 (unaudited):

	Three months ended June 30, 2006		Three months ended June 30, 2005		Six months ended June 30, 2006		Six months ended June 30, 2005
Net income (loss)	$	1,127,793	$	1,389,067	$	1,271,341	$	1,360,604
Add minority interest		657,254		820,759		740,926		783,818
Add depreciation and amortization		1,291,758		999,802		2,523,095		1,951,906
FFO	$	3,076,805	$	3,209,629	$	4,535,363	$	4,096,329
Weighted average shares outstanding		6,705,978		6,704,000		6,704,994		6,630,519
Weighted average units outstanding		3,907,607		3,817,036		3,907,607		3,817,036
Weighted average shares and units		10,613,585		10,521,036		10,612,601		10,447,555
FFO per share and unit	$	0.29	$	0.31	$	0.43	$	0.39

Liquidity and Capital Resources

As of June 30, 2006, we had cash and cash equivalents of approximately $5.9 million, of which $3.5 million was in restricted reserve accounts and real estate tax escrows. Coincident with the purchase of the Crowne Plaza Jacksonville Hotel, we placed $3.0 million into a capital improvement reserve with Mercantile Safe Deposit and Trust Company, the mortgagor’s trustee. During the six months ended June 30, 2006, approximately $1.2 million had been expended from the reserve. On May 9, 2006, we replaced our existing $23.0 million secured line of credit with a revolving credit facility for up to $60.0 million that will provide financing for future acquisitions as well as working capital. For a discussion of the new line of credit, please see Note 5, Credit Facility, to the Company’s consolidated financial statements provided in this report.

Operating Requirements.The Company finances its operations from operating cash flow, which is principally derived from the operations of its hotels. Cash flow provided by operating activities for the six months ended June 30, 2006 was approximately $4.5 million. We expect that the net cash provided by operations will be adequate to fund the Company’s operating requirements, debt service and the payment of dividends in accordance with federal income tax laws which require us make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gain. We declared dividends of $0.17 per share (unit) paid on July 11, 2006, which we funded out of working capital.

Capital Expenditures. We substantially completed renovations at three of our six initial hotels last year and have commenced renovations at the Crowne Plaza Jacksonville Hotel. During the six months ended June 30, 2006, approximately $3.2 million was spent on renovations and capital improvements. Of that amount, approximately $1.2 million was funded from the capital improvement reserve. These activities represent our net cash flow used in investing activities for the six months ended June 30, 2006 of approximately $1.9 million.

Recurring capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment, as well as debt service, are our most significant short-term liquidity requirements. During the next 12 months, we expect capital expenditures will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements required by our franchisors or capital expenditures relating to hotels we acquire in the future. With respect to two of our hotels, the reserve accounts are escrowed with funds deposited monthly (5% of gross sales), and reserved for capital projects. The Hilton Savannah DeSoto and Hilton Wilmington Riverside have these reserve accounts. Our intent for the capital reserve accounts at other hotels is to maintain overall capital expenditures at 4% of gross revenue.

On September 13, 2005, we entered into an agreement to purchase an interest in a condominium hotel property in Hollywood, Florida last operated as the Ambassador Resort. The seller will renovate the hotel and complete a condominium conversion. We will retain MHI Hotels Services to manage the hotel on its behalf. Purchase of the interest in the property and costs related to pre-opening expenses are expected to be incurred later this year and total approximately $3.0 million. Such costs will be funded by additional borrowings on the line of credit.

On June 20, 2006, the Company announced an agreement to sell the Holiday Inn Downtown Williamsburg. The Company intends to structure the disposition of the property as a “like-kind exchange” for tax purposes whereby the Company can defer recognizing gain on the sale of the property if it follows certain procedures and meets certain conditions.

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In the event we are unable to follow these procedures and meet the conditions to effect the transaction as a “like-kind exchange,” the property may be sold for cash in which case there may be expense associated with the tax indemnification agreement between the Company and the contributors of the property.

On July 6, 2006, we announced it had entered into an agreement to purchase the 186-room Louisville Ramada Riverfront Hotel in Jeffersonville, Indiana for $7.6 million. We intend to combine the proceeds of the sale of the Holiday Inn Downtown in Williamsburg, Virginia with additional borrowings on its line of credit to complete the purchase and subsequent renovations to the property. However, we may fund the purchase of the property and subsequent renovations solely from the line of credit. Renovation of the property is estimated at $7.0 million, which will be funded through borrowings on the line of credit and are expected to be complete by the end of 2007.

The Hilton licenses at our Wilmington and Savannah properties expire in 2008. As a part of the license renewal, we anticipate that significant renovations will take place at each property. Renovations at our Wilmington property will occur in 2007 and will be followed by renovations at our Savannah property. We do not expect the renovations at our Savannah property to be complete until 2008. Estimates of the cost of the renovations are not currently determinable, as the terms of the license renewals have not been fully negotiated. The renovations will be funded by our line of credit.

Debt service requirements on our borrowings will reduce our cash flows. The initial public offering and the related repayment of indebtedness on certain of our initial properties, the restructuring of management agreements and our execution of a new management agreement with lower management fees have reduced our debt service and management fee payments and, consequently, improved cash flow and liquidity in periods subsequent to the initial public offering versus periods prior to the offering.

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

• The issuance by the Company, the operating partnership of the Company, and/or their subsidiary entities of secured and unsecured debt securities;

• The incurrence by the subsidiaries of the operating partnership of mortgage indebtedness in connection with the acquisition or refinancing of hotel properties;

• The issuance of additional shares of our common stock or preferred stock;

• The issuance of additional units in the operating partnership;

• The selective disposition of non-core assets; and

• The sale or contribution of some of our wholly owned properties, development projects and development land to strategic joint ventures to be formed with unrelated investors, which would have the net effect of generating additional capital through such sale or contributions.

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

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

Inflation

We generate revenues primarily from lease payments from our TRS Lessee and net income from the operations of our TRS Lessee. Therefore, we rely primarily on the performance of the individual properties and the ability of our management company to increase revenues and to keep pace with inflation.

Operators of hotels, in general, possess the ability to adjust room rates daily to keep pace with inflation. However, competitive pressures at some or all of our hotels may limit the ability of our management company to raise room rates.

Seasonality

The operations of the properties have historically been seasonal. The periods from mid-November through mid-February are traditionally slow with the exception of the Crowne Plaza Jacksonville Hotel. The months of March and April are traditionally strong, as is October. The remaining months are generally good, but are subject to the weather and can vary significantly.

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Geographic Concentration

Our hotels are located in Florida, Georgia, North Carolina, Virginia, Maryland and Pennsylvania.

Critical Accounting Policies

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

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

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

There were no charges for impairment recorded for the three months or six months ended June 30, 2006 or 2005.

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

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

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

Income Taxes. We record a valuation allowance to reduce deferred tax assets to an amount that we believe is more likely than not to be realized. Because of expected future taxable income of our TRS lessee, we have not recorded a valuation allowance to reduce our net deferred tax asset as of June 30, 2006. Should our estimate of future taxable income be less than expected, we would record an adjustment to the net deferred tax asset in the period such determination was made.

Forward Looking Statements

Information included and incorporated by reference in this Form 10-Q may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and as

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such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words, such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and financing plans are forward-looking statements. Factors, which could have a material adverse effect on our operations and future prospects, include, but are not limited to:

• United States economic conditions generally and the real estate market specifically;

• management and performance of our hotels;

• our plans for renovation of our hotels;

• our financing plans;

• supply and demand for hotel rooms in our current and proposed market areas;

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

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

• our competition.

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

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

Item 3.Quantitative and Qualitative Disclosures About Market Risk

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

To meet in part our long-term liquidity requirements, we will borrow funds at a combination of fixed and variable rates. Our interest rate risk management objective is to limit the impact of interest rate changes on earnings and cash flows and to lower our overall borrowing costs. Our line of credit with BB&T requires us to hedge a portion of the line with an interest-rate swap which we intend to enter into in the third quarter of 2006. From time to time we may enter into other interest rate hedge contracts such as collars and treasury lock agreements in order to mitigate our interest rate risk with respect to various debt instruments. We do not intend to hold or issue these derivative contracts for trading or speculative purposes.

As of June 30, 2006, we had approximately $42.2 million of fixed-rate debt and approximately, $7.7 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 7.95%. A change in market interest rates on the fixed portion of our debt would impact the fair value of the debt, but have no impact on interest incurred or cash flows. Assuming that the amount outstanding under our line of credit remains at approximately $7.7 million, the balance at June 30, 2006, the impact on our annual interest incurred and cash flows of a one percent change in interest rate would be approximately $77,000.

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

We currently have no interest rate hedge contracts.

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Item 4.Controls and Procedures

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

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

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PART II

Item 1.Legal Proceedings

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

Item 1A.Risk Factors

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

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

Item 3.Defaults Upon Senior Securities

Not applicable.

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

None.

Item 5.Other Information

None.

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Item 6.Exhibits

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

Exhibit Number	Description of Exhibit
10.22	Purchase Agreement dated June 15, 2006
10.22A	First Amendment to Purchase Agreement dated July 25, 2006
10.22B	Second Amendment to Purchase Agreement dated August 4, 2006
31.1	Certification of President and Chief Executive Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer pursuant to Exchange Act Rules Rule 13(a)-14 and 15(d)-14, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of President and Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	MHI HOSPITALITY CORPORATION
Date: August 8, 2006	By:	/s/ Andrew M. Sims
		Andrew M. Sims
		Chief Executive Officer and Chairman of the Board

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