Sotherly Hotels (SOHO) 10-Q 2012 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, 2012

OR

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

For the transition period from to            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 Incorporation or Organization)	(I.R.S. Employer Identification No.)

410 West Francis Street, 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files.)     Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Securities Exchange Act. (Check one):

Large Accelerated Filer	¨	Accelerated Filer	¨
Non-accelerated Filer	¨	Smaller Reporting Company	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 9, 2012, there were 9,999,786 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		21
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		30
Item 4	Controls and Procedures		31
	PART II
Item 1.	Legal Proceedings		32
Item 1A.	Risk Factors		32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		32
Item 3.	Defaults Upon Senior Securities		32
Item 4.	Mine Safety Disclosures		32
Item 5.	Other Information		32
Item 6.	Exhibits		32

2

PART I

Item 1.Financial Statements

MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

	June 30, 2012			December 31, 2011
	(unaudited)
ASSETS
Investment in hotel properties, net	$	178,864,147		$	181,469,432
Investment in joint venture		8,894,509			8,966,795
Cash and cash equivalents		6,965,540			4,409,959
Restricted cash		2,335,904			2,690,391
Accounts receivable		3,385,230			1,702,616
Accounts receivable-affiliate		16,623			24,880
Prepaid expenses, inventory and other assets		2,164,384			1,877,456
Notes receivable, net		100,000			100,000
Shell Island sublease, net		600,490			720,588
Deferred income taxes		2,958,170			4,061,749
Deferred financing costs, net		2,471,556			3,275,580
TOTAL ASSETS	$	208,756,553		$	209,299,446
LIABILITIES
Line of credit	$	—		$	25,537,290
Mortgage loans		137,254,076			94,157,825
Loans payable		4,150,220			9,275,220
Series A Cumulative Redeemable Preferred Stock, par value $0.01, 27,650 shares authorized, 14,086 and 25,354 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively		14,085,669			25,353,698
Accounts payable and other accrued liabilities		8,146,331			7,437,246
Advance deposits		899,626			453,077
Dividends and distributions payable		259,573			258,772
Warrant derivative liability		5,627,975			2,943,075
TOTAL LIABILITIES		170,423,470			165,416,203
Commitments and contingencies (see Note 7)
EQUITY
MHI Hospitality Corporation stockholders’ equity
Preferred stock, par value $0.01, 972,350 shares authorized, 0 shares issued and outstanding		—			—
Common stock, par value $0.01, 49,000,000 shares authorized, 9,999,786 shares and 9,953,786 shares issued and outstanding at June 30, 2012 and December 31, 2011, respectively		99,998			99,538
Additional paid in capital		57,020,979			56,911,039
Distributions in excess of retained earnings		(26,422,738	)		(22,074,739	)
Total MHI Hospitality Corporation stockholders’ equity		30,698,239			34,935,838
Noncontrolling interest		7,634,844			8,947,405
TOTAL EQUITY		38,333,083			43,883,243
TOTAL LIABILITIES AND EQUITY	$	208,756,553		$	209,299,446

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, 2012			Three months  ended June 30, 2011			Six months  ended June 30, 2012			Six months  ended June 30, 2011
REVENUE
Rooms department	$	17,756,867		$	16,164,522		$	31,700,572		$	29,068,955
Food and beverage department		6,181,542			5,767,415			11,176,007			10,335,073
Other operating departments		1,174,113			1,197,783			2,261,088			2,261,265
Total revenue		25,112,522			23,129,720			45,137,667			41,665,293
EXPENSES
Hotel operating expenses
Rooms department		4,470,159			4,277,194			8,420,645			7,970,100
Food and beverage department		3,958,150			3,710,403			7,355,536			6,836,831
Other operating departments		117,445			141,748			240,938			262,741
Indirect		8,706,610			8,223,272			16,642,698			15,789,158
Total hotel operating expenses		17,252,364			16,352,617			32,659,817			30,858,830
Depreciation and amortization		2,195,591			2,149,910			4,375,554			4,273,387
Corporate general and administrative		962,948			848,527			2,094,534			1,805,621
Total operating expenses		20,410,903			19,351,054			39,129,905			36,937,838
NET OPERATING INCOME		4,701,619			3,778,666			6,007,762			4,727,455
Other income (expense)
Interest expense		(4,283,732	)		(2,720,121	)		(7,572,362	)		(5,305,548	)
Interest income		3,169			4,602			7,852			7,538
Equity income (loss) in joint venture		(88,080	)		(166,981	)		177,714			122,456
Unrealized (loss) on warrant derivative		(1,521,142	)		(380,000	)		(2,684,900	)		(380,000	)
Unrealized gain on hedging activities		—			22,612			—			72,649
Gain on disposal of assets		—			6,055			—			12,255
Net income (loss) before income taxes		(1,188,166	)		544,833			(4,063,934	)		(743,195	)
Provision for income tax		(958,146	)		(788,334	)		(1,062,721	)		(836,776	)
Net (loss)		(2,146,312	)		(243,501	)		(5,126,655	)		(1,579,971	)
Add: Net loss attributable to the noncontrolling interest		492,658			60,939			1,178,647			408,090
NET (LOSS) ATTRIBUTABLE TO THE COMPANY	$	(1,653,654	)	$	(182,562	)	$	(3,948,008	)	$	(1,171,881	)
Net (loss) per share attributable to the Company
Basic	$	(0.17	)	$	(0.02	)	$	(0.40	)	$	(0.12	)
Diluted	$	(0.16	)	$	(0.02	)	$	(0.38	)	$	(0.12	)
Weighted average number of shares outstanding
Basic		9,999,786			9,617,116			9,991,445			9,588,996
Diluted		10,623,642			9,977,328			10,442,799			9,770,097

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

4

MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

(unaudited)

	Common Stock				Additional Paid- In Capital		Distributions in Excess of Retained Earnings			Noncontrolling Interest			Total
	Shares		Par Value
Balances at December 31, 2011		9,953,786	$	99,538	$	56,911,039	$	(22,074,739	)	$	8,947,405		$	43,883,243
Issuance of restricted common stock awards		46,000		460		109,940		—			—			110,400
Dividends and distributions declared		—		—		—		(399,991	)		(119,274	)		(519,265	)
Redemption of units in operating partnership		—		—		—		—			(14,640	)		(14,640	)
Net loss		—		—		—		(3,948,008	)		(1,178,647	)		(5,126,655	)
Balances at June 30, 2012		9,999,786	$	99,998	$	57,020,979	$	(26,422,738	)	$	7,634,844		$	38,333,083

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, 2012			Six months  ended June 30, 2011
Cash flows from operating activities:
Net loss		$	(5,126,655	)	$	(1,579,971	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization			4,375,554			4,273,387
Equity income in joint venture			(177,714	)		(122,456	)
Unrealized loss on warrant derivative			2,684,900			380,000
Unrealized gain on hedging activities			—			(72,649	)
Gain on disposal of assets			—			(12,255	)
Amortization of deferred financing costs			1,628,344			691,028
Paid-in-kind interest			245,573			100,000
Charges related to equity-based compensation			110,400			74,930
Changes in assets and liabilities:
Restricted cash			444,269			(60,989	)
Accounts receivable			(1,682,614	)		(795,349	)
Prepaid expenses, inventory and other assets			(323,045	)		(223,609	)
Deferred income taxes			1,103,579			767,174
Accounts payable and other accrued liabilities			1,258,711			1,326,576
Advance deposits			446,549			150,014
Due from affiliates			8,257			(1,124	)
Net cash provided by operating activities			4,996,108			4,894,707
Cash flows from investing activities:
Improvements and additions to hotel properties			(2,163,680	)		(3,221,595	)
Proceeds from sale of furniture and equipment			—			12,255
Distributions from joint venture			250,000			187,500
Funding of restricted cash reserves			(993,239	)		(1,161,324	)
Proceeds of restricted cash reserves			903,457			850,022
Net cash used in investing activities			(2,003,462	)		(3,333,142	)
Cash flows from financing activities:
Proceeds of redeemable preferred stock			—			25,000,000
Redemption of redeemable preferred stock	��		(11,513,602	)		—
Payments on credit facility			(25,537,290	)		(22,697,858	)
Proceeds of mortgage debt			44,000,000			—
Dividends and distributions paid			(518,465	)		—
Redemption of units in operating partnership			(14,640	)		—
Pledge of cash collateral			—			(750,000	)
Payment of deferred financing costs			(824,319	)		(1,275,803	)
Payments on mortgage debt and loans			(6,028,749	)		(495,754	)
Net cash used in financing activities			(437,065	)		(219,415	)
Net increase in cash and cash equivalents			2,555,581			1,342,150
Cash and cash equivalents at the beginning of the period			4,409,959			2,992,888
Cash and cash equivalents at the end of the period		$	6,965,540		$	4,335,037
Supplemental disclosures:
Cash paid during the period for interest		$	6,062,706		$	4,083,230
Cash paid during the period for income taxes		$	104,595		$	42,654

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-managed and self-administered real estate investment trust (“REIT”) that was incorporated in Maryland on August 20, 2004 to own primarily full-service upper-upscale and upscale hotels located in primary and secondary markets in the Mid-Atlantic and Southern United States. The hotels operate under well-known national hotel brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn.

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 (the “initial properties”). Substantially all of the Company’s assets are held by, and all of its operations are conducted through, MHI Hospitality, L.P. (the “Operating Partnership”). The Company also owns a 25.0% noncontrolling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with CRP/MHI Holdings, LLC, an affiliate of both Carlyle Realty Partners V, L.P. and The Carlyle Group (“Carlyle”).

For the Company to qualify as a REIT, it cannot operate hotels. Therefore, the Operating Partnership, which, at June 30, 2012, was approximately 77.0% 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, MHI Hotels Services, LLC (“MHI Hotels Services”), to operate the hotels under a management contract. MHI TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

All references in this report to the “Company”, “MHI”, “we”, “us” and “our” refer to MHI Hospitality Corporation, its Operating Partnership and its subsidiaries and predecessors, unless the context otherwise requires or where otherwise indicated.

Significant transactions occurring during the current and prior fiscal year include the following:

On April 18, 2011, the Company entered into a sixth amendment to the credit agreement. Among other things, the amendment: (i) extended the final maturity date of the credit facility to May 8, 2014; (ii) provided that no additional advances may be made and no currently outstanding advances subsequently repaid or prepaid may be re-borrowed; (iii) adjusted the release amounts with respect to secured hotel properties; (iv) reduced the additional interest from 4.00% to 3.50% and removed the LIBOR floor of 0.75%; and (v) adjusted certain financial covenants including restrictions relating to payment of dividends. In connection with the amendment, the Company reduced the outstanding balance on its then-existing credit facility by approximately $22.7 million.

On April 18, 2011, the Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) with Essex Illiquid, LLC and Richmond Hill Capital Partners, LP (collectively, the “Investors”), under which the Company issued and sold to the Investors in a private placement 25,000 shares of the Company’s Series A Cumulative Redeemable Preferred Stock (the “Preferred Stock”), and a warrant (the “Warrant”) to purchase 1,900,000 shares of the Company’s common stock, par value $0.01 per share, for a purchase price of $25.0 million. The Company used the net proceeds from the issuance of the Preferred Stock and the Warrant to partially prepay the amounts owed by the Company under its credit agreement.

On April 18, 2011, the Company entered into an agreement with Essex Equity High Income Joint Investment Vehicle, LLC, pursuant to which the Company has the right to borrow up to $10.0 million on or before December 31, 2011 (the “Bridge Financing”). The principal amount borrowed bears interest at the rate of 9.25% per annum, payable quarterly in arrears and will mature on the earlier of April 18, 2015 or the redemption in full of the Preferred Stock.

On June 30, 2011, the Company entered into an agreement with TowneBank to extend the maturity of the mortgage on the Crowne Plaza Hampton Marina until June 30, 2012. Under the terms of the extension, the Company will make monthly principal payments of $16,000. Interest payable monthly pursuant to the mortgage was increased to LIBOR plus additional interest of 4.55% and a minimum total rate of interest of 5.00%. The Company also pledged $750,000 in cash collateral held by the lender in an interest-bearing account.

On August 1, 2011, the Company entered into agreements with PNC Bank, National Association, in its capacity as trustee of the AFL-CIO Building Investment Trust, to extend the maturity of the mortgage on the Crowne Plaza Jacksonville Riverfront until January 22, 2013. During the extension, and pursuant to the loan documents, the interest rate applicable to the mortgage loan is fixed at 8.0% and the lender has waived certain covenants requiring the borrower to further pay down principal under certain circumstances. In order to effect the extension, and pursuant to the loan documents, the Company tendered to the lender the sum of $4.0 million as principal curtailment of the mortgage loan, thus reducing the mortgage loan’s current outstanding principal amount to $14.0 million, and the lender waived certain covenants requiring the Company to further pay down principal under certain circumstances.

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On August 5, 2011, the Company obtained a 10-year, $7.5 million mortgage with Bank of Georgetown on the Holiday Inn Laurel West hotel property. The mortgage bears interest at a rate of 5.25% per annum for the first five years. After five years, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current 5-year U.S. Treasury bill rate of interest, with a floor of 5.25%. The mortgage provides for level payments of principal and interest on a monthly basis under a 25-year amortization schedule. Proceeds of the mortgage were used to pay down a portion of the Company’s indebtedness under its then-existing credit facility.

On October 17, 2011, the Company obtained a 5-year, $8.0 million mortgage with Premier Bank, Inc. on its property in Raleigh, North Carolina. The mortgage bears interest at a rate of 5.25% per annum and provides for level payments of principal and interest on a monthly basis under a 25-year amortization schedule. The mortgage may be extended for an additional 5-year period, at the Company’s option if certain conditions have been satisfied, at a rate of 3.00% per annum plus the then-current 5-year U.S. Treasury bill rate of interest. Proceeds of the mortgage were used to pay down a portion of the Company’s indebtedness under its then-existing credit facility.

On December 15, 2011, the Company obtained a 5-year, $12.2 million mortgage with Goldman Sachs Commercial Mortgage Capital, L.P. on the Sheraton Louisville Riverside in Jeffersonville, Indiana. The mortgage bears interest at a rate of 6.2415% per annum and provides for level payments of principal and interest on a monthly basis under a 25-year amortization schedule. Proceeds of the mortgage were used to pay down a portion of the Company’s indebtedness under its then-existing credit facility.

On December 21, 2011, the Company entered into an amendment of its Bridge Financing to extend the lender’s loan commitment by 17 months through May 31, 2013.

On December 21, 2011, the Company also amended the terms of the outstanding Warrant issued by the Company in favor of the Investors. Pursuant to the Warrant amendment, the exercise price per share of common stock covered by the Warrant will be adjusted from time to time in the event of cash dividends upon common stock by deducting from such exercise price the per-share amount of such cash dividends. Such adjustment does not take in to account quarterly dividends declared prior to January 1, 2012.

On March 5, 2012, the Company obtained a $30.0 million mortgage with TD Bank, N.A. on the Hilton Philadelphia Airport. The mortgage bears interest at a rate of 30-day LIBOR plus additional interest of 3.0% per annum and provides for level payments of principal and interest on a monthly basis under a 25-year amortization schedule. The mortgage’s maturity date is August 30, 2014, with an extension option until March 1, 2017, contingent upon the extension or acceptable replacement of the Hilton Worldwide license agreement. Proceeds of the mortgage were used to extinguish the Company’s indebtedness under the then-existing credit facility, prepay a portion of the Company’s indebtedness under the Bridge Financing and for working capital. With this transaction, the Company’s syndicated credit facility was extinguished and the Crowne Plaza Tampa Westshore hotel property was released from any mortgage encumbrance.

On June 15, 2012, the Company entered into an amendment of its Bridge Financing that provides, subject to a $1.5 million prepayment which the Company made on June 18, 2012, that the amount of undrawn term loan commitments will be increased to $7.0 million, of which $2.0 million is reserved to repay principal amounts outstanding on the Crowne Plaza Jacksonville Riverfront hotel property.

On June 15, 2012, the Company simultaneously entered into an agreement with the holders of the Company’s Preferred Stock to redeem approximately 11,514 shares of Preferred Stock for an aggregate redemption price of approximately $12.3 million plus the payment of related accrued and unpaid cash and stock dividends.

On June 18, 2012, the Company obtained a $14.0 million mortgage with C1 Bank on the Crowne Plaza Tampa Westshore in Tampa, Florida. The mortgage bears interest at a rate of 5.60% per annum and provides for level payments of principal and interest on a monthly basis under a 25-year amortization schedule. The mortgage’s maturity date is June 18, 2017. Proceeds of the mortgage were used to pay the outstanding indebtedness under the Bridge Financing and to redeem approximately 11,514 shares of Preferred Stock.

On June 22, 2012, the Company entered into an agreement with TowneBank to extend the maturity of the mortgage on the Crowne Plaza Hampton Marina in Hampton, Virginia, until June 30, 2013. Under the terms of the extension, the Company will continue to make monthly principal payments of $16,000 and will also make quarterly principal payments to the lender of $200,000 each on July 1, 2012, October 1, 2012, January 1, 2013 and April 1, 2013. Interest payable monthly pursuant to the mortgage will remain at a rate of LIBOR plus additional interest of 4.55% and a minimum total rate of interest of 5.00% per annum.

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, the Operating Partnership, MHI TRS and subsidiaries as of June 30, 2012 and December 31, 2011 and for the three months and six months ended June 30, 2012 and 2011. All significant inter-company balances and transactions have been eliminated.

Investment in Hotel Properties –Investments in hotel properties include investments in operating properties which are recorded at acquisition cost and allocated to land, property and equipment and identifiable intangible assets. 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.

8

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 7 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.

Investment in Joint Venture – Investment in joint venture represents the Company’s noncontrolling indirect 25.0% equity interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel under a management contract; (iii) the entity that had an option to purchase a three-acre development site with parking garage adjacent to the hotel and which leased the parking garage for use by the hotel; and (iv) the entity that owned the $22.0 million junior participation in the existing mortgage. Carlyle owns a 75.0% controlling indirect interest in all these entities. The Company accounts for its investment in the joint venture under the equity method of accounting and is entitled to receive its pro rata share of annual cash flow. The Company also has the opportunity to earn an incentive participation in the net sale proceeds based upon the achievement of certain overall investment returns, in addition to its pro rata share of net sale proceeds.

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

Concentration of Credit Risk –The Company holds cash accounts at several institutions in excess of the Federal Deposit Insurance Corporation (the “FDIC”) protection limits of $250,000. The Company’s exposure to credit loss in the event of the failure of these institutions is represented by the difference between the FDIC protection limit and the total amounts on deposit. Management monitors, on a regular basis, the financial condition of the financial institutions along with the balances there on deposit to minimize the Company’s potential risk.

Restricted Cash –Restricted cash includes real estate tax escrows, insurance escrows and reserves for replacements of furniture, fixtures and equipment pursuant to certain requirements in the Company’s various mortgage agreements and line of credit.

Inventories – Inventories which consist primarily of food and beverage are stated at the lower of cost or market, with cost determined on a method that approximates first-in, first-out basis.

Franchise License Fees –Fees expended to obtain or renew a franchise license are amortized over the life of the license or renewal. The un-amortized franchise fees as of June 30, 2012 and December 31, 2011 were $262,339 and $284,090, respectively. Amortization expense for the three months and six months ended June 30, 2012 totaled $10,775 and $21,650, respectively and $11,587 and $23,165, respectively for the three months and six months ended June 30, 2011.

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.

Derivative Instruments –The Company’s derivative instruments are reflected as assets or liabilities on 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 an interest rate risk, are considered fair value hedges. Derivative instruments used to hedge 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 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 uses derivative instruments to add stability to interest expense and to manage its exposure to interest-rate movements. To accomplish this objective, the Company primarily used an interest-rate swap, which was required under its credit agreement and acted as a cash flow hedge involving the receipts of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments without exchange of the underlying principal amount. The Company valued its interest-rate

9

swap at fair value, which it defines as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price) and included it in accounts payable and accrued liabilities. The Company also uses derivative instruments in the Company’s stock to obtain more favorable terms on its financing. The Company does not enter into contracts to purchase or sell derivative instruments for speculative trading purposes.

The Company classifies the inputs used to measure fair value into the following hierarchy:

Level 1 Unadjusted quoted prices in active markets for identical assets or liabilities.

Level 2 Unadjusted quoted prices in active markets for similar assets or liabilities, or Unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or Inputs other than quoted prices that are observable for the asset or liability.

Level 3 Unobservable inputs for the asset or liability.

The Company endeavors to utilize the best available information in measuring fair value. Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The following table represents our derivative instruments measured at fair value and the basis for that measurement:

	Level 1		Level 2			Level 3
June 30, 2012
Interest-rate swap	$	—	$	—		$	—
Warrant		—		(5,627,975	)		—
December 31, 2011
Interest-rate swap		—		—			—
Warrant		—		(2,943,075	)		—

The Company’s warrant derivative liability was valued at June 30, 2012 and December 31, 2011 using the Monte Carlo simulation method which is a generally accepted statistical method used to generate a defined number of stock price paths in order to develop a reasonable estimate of the range of our and our peer group’s future expected stock prices and minimizes standard error. The Monte Carlo simulation method takes into account, as of the valuation date, factors including the exercise, the remaining term of the warrant, the current price of the underlying stock and its expected volatility, expected dividends on the stock and the risk-free interest rate for the term of the warrant.

Cumulative Mandatorily Redeemable Preferred Stock– The Company accounts for its preferred stock based upon the guidance enumerated in ASC 480,Distinguishing Liabilities from Equity. The Preferred Stock is mandatorily redeemable on April 18, 2016, or upon the earlier occurrence of certain triggering events and therefore is classified as a liability instrument on the date of issuance.

Warrants—The Company accounts for the warrant based upon the guidance enumerated in ASC 815-40,Derivatives and Hedging: Contracts in Entity’s Own Stock. The Warrant contains a provision that could require an adjustment to the exercise price if we issued securities deemed to be dilutive to the Warrant and therefore is classified as a derivative liability. The Warrant is carried at fair value with changes in fair value reported in earnings as long as the Warrant remains classified as a derivative liability.

Noncontrolling 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 noncontrolling 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 noncontrolling 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, parking, gift shop sales, and rentals from restaurant tenants, rooftop leases and gift shop operators.

Occupancy and Other Taxes –Revenues are reported net of occupancy and other taxes collected from customers and remitted to governmental authorities.

Income Taxes –The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, the Company generally will not be subject to federal income tax on that portion of its net income 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 subsidiaries of the Operating Partnership, is subject to federal and state income taxes.

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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. As of June 30, 2012, the Company has no uncertain tax positions. In addition, the Company recognizes obligations for interest and penalties related to uncertain tax positions, if any, as income tax expense. The period from December 21, 2004 through December 31, 2011 remains open to examination by the major taxing jurisdictions to which the Company is subject.

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

Under the Plan, the Company has made restricted stock and deferred stock awards totaling 261,938 shares including 195,438 shares issued to certain executives and employees, and 65,000 restricted shares and 1,500 unrestricted shares issued to its independent directors. Of the 195,438 shares issued to certain of the Company’s executives and employees, all have vested except 7,000 shares issued to the Vice President and General Counsel upon execution of his employment contract which will vest on the anniversary of the effective date of his employment agreement next year. Regarding the restricted shares awarded to the Company’s independent directors, all of the shares have vested except 15,000 shares which vest at the end of 2012.

The value of the awards is 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, 2012, no performance-based stock awards have been granted. Consequently, stock-based compensation as determined under the fair-value method would be the same under the intrinsic-value method. Compensation cost recognized under the Plan was $13,077 and $26,155, respectively, for the three months and six months ended June 30, 2012 and $11,698 and $23,395, respectively for the three months and six months ended June 30, 2011.

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 –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.

Recent Accounting Pronouncements – There are no recent accounting pronouncements which the Company believes will have a material impact on its financial statements.

3. Acquisition of Hotel Properties

There were no new acquisitions during the six months ended June 30, 2012.

4. Investment in Hotel Properties

Investment in hotel properties as of June 30, 2012 and December 31, 2011 consisted of the following (in thousands):

	June 30, 2012			December 31, 2011
	(unaudited)
Land and land improvements	$	19,404		$	19,374
Buildings and improvements		180,610			179,585
Furniture, fixtures and equipment		32,859			32,419
		232,873			231,378
Less: accumulated depreciation		(54,009	)		(49,909	)
	$	178,864		$	181,469

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5. Debt

Credit Facility.During 2011 and a portion of the six months ended June 30, 2012, the Company had a secured credit facility with a syndicated bank group comprised of BB&T, Key Bank National Association and Manufacturers and Traders Trust Company. The credit facility was established during the second quarter of 2006 and replaced a $23.0 million secured, revolving credit facility with BB&T. On March 5, 2012, the Company extinguished the credit facility in conjunction with the refinance of the mortgage on the Hilton Philadelphia Airport.

On June 4, 2010, the Company entered into a fifth amendment to its credit agreement modifying certain provisions of the agreement including an increase in the rate of interest to LIBOR plus additional interest of 4.00%; a LIBOR floor of 0.75%; a conversion to a non-revolving facility; a provision for mandatory quarterly pre-payments based on excess cash flow, as defined in the amendment, as well as a mandatory prepayment if the Company raises equity within certain parameters; and provided an option to extend the maturity for one year if certain conditions were met.

On April 18, 2011, the Company entered into a sixth amendment to the credit agreement which, among other things, (i) extended the final maturity date of advances under the credit agreement to May 8, 2014; (ii) provided that no additional advances may be made and no currently outstanding advances subsequently repaid or prepaid may be re-borrowed; (iii) adjusted the release amounts with respect to secured hotel properties; (iv) reduced the additional interest from 4.00% to 3.50% and removed the LIBOR floor of 0.75%; and (v) adjusted certain financial covenants including restrictions relating to payment of dividends. In connection with the amendment, the Company reduced the outstanding balance on its then-existing credit facility by approximately $22.7 million.

The Company had borrowings under the credit facility of approximately $0.0 million and approximately $25.5 million at June 30, 2012 and December 31, 2011, respectively.

Mortgage Debt.As of June 30, 2012 and December 31, 2011, the Company had approximately $137.3 million and $94.2 million of outstanding mortgage debt, respectively. The following table sets forth the Company’s mortgage debt obligations on its hotels:

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Property	Balance Outstanding as of				Prepayment Penalties	Maturity Date			Amortization Provisions			Interest Rate
	June 30, 2012		December 31, 2011
Crowne Plaza Hampton Marina	$	8,055,625	$	8,151,625	None		06/2013		$	16,000	(1)		LIBOR plus  4.55	%(2)
Crowne Plaza Jacksonville Riverfront		14,000,000		14,000,000	None(3)		01/2013			Interest Only			8.00	%
Crowne Plaza Tampa Westshore		14,000,000		—	None		06/2017			25 years			5.60	%
DoubleTree by Hilton Brownstone – University		7,896,813		7,980,385	Yes(4)		10/2016	(5)		25 years			5.25	%
Hilton Philadelphia Airport		29,876,736		—	None		08/2014	(6)		25 years			LIBOR plus  3.00	%(7)
Hilton Savannah DeSoto		22,273,421		22,488,916	(8)		07/2017			25 years	(9)		6.06	%
Hilton Wilmington Riverside		21,654,539		21,884,909	(8)		03/2017			25 years	(10)		6.21	%
Holiday Inn Laurel West		7,378,382		7,451,990	Yes(11)		08/2021			25 years			5.25	%(12)
Sheraton Louisville Riverside		12,118,560		12,200,000	(13)		01/2017			25 years			6.24	%
Total	$	137,254,076	$	94,157,825

(1) The Company is required to make monthly principal payments of $16,000 as well as quarterly principal payments of $200,000 each on July 1, 2012, October 1, 2012, January 1, 2013 and April 1, 2013.

(2) The note bears a minimum interest rate of 5.00%.

(3) The note could not be prepaid prior to July 2009, but a prepayment may be made currently without penalty.

(4) The note may be partially prepaid to a maximum of 20% of the original loan amount without penalty. Pre-payment greater than 20% of the original loan amount can be made with penalty until 180 days before the original maturity or as extended maturity, if applicable.

(5) The note provides that after five years, the mortgage can be extended if certain conditions have been satisfied for additional five year period at a rate of 3.00% per annum plus the then-current 5-year U.S. Treasury rate of interest.

(6) The note provides that the mortgage can be extended if certain conditions have been satisfied until March 2017.

(7) The note bears a minimum interest rate of 3.50%.

(8) The notes may not be prepaid during the first six years of the terms. Prepayment can be made with penalty thereafter until 90 days before maturity.

(9) The note provided for payments of interest only until August 2010 after which payments of principal and interest under a 25-year amortization schedule are due until the note matures in July 2017.

(10) The note provided for payments of interest only until March 2009 after which payments of principal and interest under a 25-year amortization schedule are due until the note matures in March 2017.

(11) Pre-payment can be made with penalty until 180 days before the fifth anniversary of the commencement date of the loan or from such date until 180 days before the maturity.

(12) The note provides that after five years, the rate of interest will adjust to a rate of 3.00% per annum plus the then-current 5-year U.S. Treasury rate of interest, with a floor of 5.25%.

(13) With limited exception, the note may not be prepaid until two months before maturity.

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Total mortgage debt maturities as of June 30, 2012 without respect to any additional loan extensions for the following twelve-month periods were as follows:

June 30, 2013	$	24,531,830
June 30, 2014		2,607,256
June 30, 2015		30,266,568
June 30, 2016		2,045,092
June 30, 2017		51,565,657
Thereafter		26,237,673
Total future maturities	$	137,254,076

Other Loans.On February 9, 2009, the indirect subsidiary of the Company which is a member of the joint venture entity that owns the Crowne Plaza Hollywood Beach Resort, borrowed $4.75 million from the Carlyle entity that is the other member of such joint venture (the “Carlyle Affiliate Lender”), for the purpose of improving the Company’s liquidity. In June 2008, the joint venture that owns the property purchased a junior participation in a portion of the mortgage loan from the lender. The amount of the loan from the Carlyle Affiliate Lender approximated the amount the Company contributed to the joint venture to enable the joint venture to purchase its interest in the mortgage loan. The interest rate and maturity date of the loan are tied to a note that is secured by a mortgage on the property. The loan, which currently bears a rate of LIBOR plus additional interest of 3.00%, requires monthly payments of interest and principal equal to 50.0% of any distributions it receives from the joint venture. The maturity date of the mortgage to which the loan is tied matures in August 2014. The outstanding balance on the loan at June 30, 2012 and December 31, 2011 was $4,150,220 and $4,275,220, respectively.

Available Bridge Financing. On April 18, 2011, the Company entered into an agreement with Essex Equity High Income Joint Investment Vehicle, LLC, pursuant to which the Company had the right to borrow up to $10.0 million before the earlier of December 31, 2011 or the redemption in full of the Preferred Stock. On December 21, 2011, the Company entered into an amendment to the agreement extending the right to borrow the remainder of the available financing to May 31, 2013. The principal amount borrowed bears interest at the rate of 9.25% per annum, payable quarterly in arrears. The Bridge Financing will mature on April 18, 2015 or upon the redemption in full of the Preferred Stock, if earlier. The outstanding balance may be prepaid at the Company’s option in whole or in part at any time without penalty. Further, the Company is obligated (i) to make prepayments in the event of, and to the extent of the proceeds from, new equity issuances, certain debt incurrences and sales of assets and (ii) to repay the Bridge Financing in full following certain trigger events which also give rise to an obligation to redeem the outstanding shares of Preferred Stock. The agreement provides for certain future securities pledges and/or asset liens to be granted from time to time to the lender to secure the Bridge Financing, under the circumstances and upon the conditions set forth in the agreement. The outstanding balance on the Bridge Financing at June 30, 2012 and December 31, 2011 was $0.0 million and $5.0 million, respectively. At June 30, 2012, the Company had borrowing capacity under the Bridge Financing of $7.0 million.

6. Mandatorily Redeemable Preferred Stock and Warrant

On April 18, 2011, the Company completed a private placement to the Investors pursuant to the Securities Purchase Agreement for gross proceeds of $25.0 million. The Company issued 25,000 shares of Preferred Stock and the Warrant to purchase 1,900,000 shares of the Company’s common stock, par value $0.01 per share.

The Company has designated a class of preferred stock, the Preferred Stock, consisting of 27,650 shares with $0.01 par value per share, having a liquidation preference of $1,000.00 per share pursuant to Articles Supplementary (the “Articles Supplementary”), which sets forth the preferences, rights and restrictions for the Preferred Stock. The Preferred Stock is non-voting and non-convertible. The holders of the Preferred Stock have a right to payment of a cumulative dividend payable quarterly (i) in cash at an annual rate of 10.0% of the liquidation preference per share and (ii) in additional shares of Preferred Stock at an annual rate of 2.0% of the liquidation preference per share. As set forth in the Articles Supplementary, the holder(s) of the Company’s Preferred Stock will have the exclusive right, voting separately as a single class, to elect one (1) member of the Company’s board of directors. In addition, under certain circumstances as set forth in the Articles Supplementary, the holder(s) of the Company’s Preferred Stock will be entitled to appoint a majority of the members of the board of directors. The holder(s) of the Company’s Preferred Stock will be entitled to require that the Company redeem the Preferred Stock under certain circumstances, but no later than April 18, 2016, and on such terms and at such price as is set forth in the Articles Supplementary.

On June 15, 2012, the Company entered into an agreement with the holders of the Company’s Preferred Stock to redeem approximately 11,514 shares of Preferred Stock for an aggregate redemption price of approximately $12.3 million plus the payment of related accrued and unpaid cash and stock dividends. The redemption resulted in a prepayment fee of approximately $0.8 million. In addition, approximately $0.7 million in unamortized issuance costs related to the redeemed shares were written off. On June 18, 2012, the Company used a portion of the proceeds of the mortgage on the Crowne Plaza Tampa Westshore to redeem approximately 11,514 shares of Preferred Stock. As of June 30, 2012 and December 31, 2011, there were approximately 14,086 and 25,354 shares of the Preferred Stock issued and outstanding, respectively.

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The Warrant, as modified, entitles the holder(s) to purchase up to 1,900,000 shares of the Company’s common stock. Pursuant to the Warrant amendment, the exercise price per share of common stock covered by the Warrant will be adjusted from time to time in the event of cash dividends upon common stock by deducting from such exercise price the per-share amount of such cash dividends. Such adjustment does not take into account quarterly dividends declared prior to January 1, 2012. At June 30, 2012, the adjusted exercise price was $2.21 per share. The Warrant expires on October 18, 2016. The Warrant holders have no voting rights. The exercise price and number of shares of common stock issuable upon exercise of the Warrant are both subject to additional adjustments under certain circumstances. The Warrant also contains a cashless exercise right. Under certain circumstances as set forth in the Warrant, the holders of the Warrant will be entitled to participate in certain future securities offerings of the Company.

The Company determined the fair market value of the Warrant was approximately $1.6 million on the issuance date using the Black-Scholes option pricing model assuming an exercise price of $2.25 per share of common stock, a risk-free interest rate of 2.26%, a dividend yield of 5.00%, expected volatility of 60.0%, and an expected term of 5.5 years, and is included in deferred financing costs. The deferred cost is amortized to interest expense in the accompanying consolidated statement of operations over the period of issuance to the mandatory redemption date of the preferred stock.

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. In December 2007, the Company signed an amendment to the lease to include rights to the outdoor esplanade adjacent to the leased commercial space. These areas are leased under a six-year operating lease, which expired October 31, 2006 and has been renewed for the second of three optional five-year renewal periods expiring October 31, 2011, October 31, 2016 and October 31, 2021, respectively. Rent expense for the three months and six months ended June 30, 2012 totaled $16,195 and $32,062, respectively, and totaled $16,210 and $33,426 for the three months and six months ended June 30, 2011, respectively, for this operating lease.

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 Doubletree by Hilton Brownstone-University 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 the three months and six months ended June 30, 2012 totaled $23,871 and $47,741, respectively, and totaled $23,871 and $47,741 for the three months and six months ended June 30, 2011, respectively.

In conjunction with the sublease arrangement for the property at Shell Island which expired in December 2011, the Company incurred an annual lease expense for a leasehold interest. Lease expense totaled $38,750 and $97,500 for the three months and six months ended June 30, 2011, respectively.

The Company leases a parking lot adjacent to the Crowne Plaza Tampa Westshore under a five-year agreement with the Florida Department of Transportation that commenced in July 2009 and expires in July 2014. The agreement requires annual payments of $2,432, plus tax, and may be renewed for an additional five years. Rent expense totaled $613 and $1,226 for the three months and six months ended June 30, 2012, respectively, and totaled $689 and $1,378 for the three months and six months ended June 30, 2011, 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, 2012 requiring annual payments of $4,961. Rent expense totaled $1,240 and $2,480 for the three months and six months ended June 30, 2012, respectively, and totaled $1,240 and $2,480 for the three months and six months ended June 30, 2011, respectively.

The Company leases 3,542 square feet of commercial office space in Williamsburg, Virginia under an agreement that commenced September 1, 2009 and expires August 31, 2015. Rent expense totaled $13,750 and $27,500 for the three months and six months ended June 30, 2012, respectively, and totaled $13,750 and $27,500 for the three months and six months ended June 30, 2011, respectively.

The Company leases 1,632 square feet of commercial office space in Rockville, Maryland under an agreement that commenced December 14, 2009 and expires February 28, 2017. The agreement requires monthly payments at an annual rate of $22,848 for the first year of the lease term and monthly payments at an annual rate of $45,696 for the second year of the lease term, increasing 2.75% per year for the remainder of the lease term. Rent expense totaled $11,181 and $22,272 for the three months and six months ended June 30, 2012, respectively, and totaled $11,046 and $22,229 for the three months and six months ended June 30, 2011, respectively.

15

The Company also leases certain furniture and equipment under financing arrangements expiring between February 2013 and December 2014.

A schedule of minimum future lease payments for the following twelve-month periods is as follows:

June 30, 2013	$	528,756
June 30, 2014		365,702
June 30, 2015		296,260
June 30, 2016		222,770
June 30, 2017		75,132
Thereafter		—
Total future minimum lease payments	$	1,488,620

Management Agreements – Each of the operating hotels that the Company wholly-owned at June 30, 2012, except for the Crowne Plaza Tampa Westshore, are operated by MHI Hotels Services under a master management agreement that expires between December 2014 and April 2018. The Company entered into a separate management agreement with MHI Hotels Services for the management of the Crowne Plaza Tampa Westshore that expires in March 2019 (see Note 9).

Franchise Agreements – As of June 30, 2012, the Company’s 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. The franchise agreements currently expire between October 2014 and April 2023.

Restricted Cash Reserves – Each month, 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 by several of its lenders to establish individual property improvement funds to cover the cost of replacing capital assets at its properties. Each month, contributions equal 4.0% of gross revenues for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside, the Sheraton Louisville Riverside and the Crowne Plaza Hampton Marina and equal 4.0% of room revenues for the Crowne Plaza Jacksonville Riverfront and the Hilton Philadelphia Airport.

Pursuant to the terms of the fifth amendment to the credit agreement and until its termination in March 2012, the Company was required to escrow with its lender an amount sufficient to pay the real estate taxes as well as property and liability insurance for the encumbered properties when due. In addition, the Company was required to make monthly contributions equal to 3.0% of room revenues into a property improvement fund.

Litigation – The Company is not involved in any material litigation, nor, to its knowledge, is any material litigation threatened against the Company. The Company is involved in routine legal proceedings arising out of the ordinary course of business, all of which the Company expects to be covered by insurance. The Company does not expect any pending legal proceedings to have a material impact on its financial condition or results of operations.

8. Stockholders’ Equity

Preferred Stock– The Company has authorized 1,000,000 shares of preferred stock, of which 27,650 shares have been designated Series A Cumulative Redeemable Preferred Stock, as described above. None of the remaining authorized shares have been issued.

Common Shares –The Company is authorized to issue up to 49,000,000 shares of common stock, $0.01 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 January 25, 2011, the Company issued 16,000 non-restricted shares to its Chief Operating Officer and President in accordance with the terms of his employment contract, as amended.

On March 22, 2011, the Company issued 17,500 shares of non-restricted stock to certain executives and employees as well as 12,000 shares of restricted stock to its then serving independent directors.

On June 7, 2011, one holder of units in the Operating Partnership redeemed 115,000 units for an equivalent number of shares of the Company’s common stock.

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On October 3, 2011, one holder of units in the Operating Partnership redeemed 50,000 units for an equivalent number of shares of the Company’s common stock.

On November 1, 2011, one holder of units in the Operating Partnership redeemed 15,000 units for an equivalent number of shares of the Company’s common stock.

On December 1, 2011, one holder of units in the Operating Partnership redeemed 187,000 units for an equivalent number of shares of the Company’s common stock.

On February 2, 2012, the Company awarded 29,500 shares of unrestricted stock to certain executives and employees as well as 1,500 shares of unrestricted stock and 15,000 shares of restricted stock to its independent directors.

As of June 30, 2012 and December 31, 2011, the Company had 9,999,786 and 9,953,786 shares of common stock outstanding, respectively.

Warrants –The Company has granted no warrants representing the right to purchase common stock other than the Warrant described in Note 6.

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.

On November 1, 2011 and May 1, 2012, the Company redeemed 2,600 and 6,000 units, respectively, in the Operating Partnership held by a trust controlled by two members of the Board of Directors for a total of $21,790 pursuant to the terms of the partnership agreement.

As of June 30, 2012, the total number of Operating Partnership units outstanding was 2,978,839, with a fair market value of approximately $10.7 million based on the price per share of the common stock on that date.

9. Related Party Transactions

As of June 30, 2012, the members of MHI Hotels Services (a company that is majority-owned and controlled by the Company’s chief executive officer, its chief financial officer and a current and former member of its Board of Directors) owned approximately 10.9% of the Company’s outstanding common stock and 1,851,670 Operating Partnership units. The following is a summary of the transactions between the Company and MHI Hotels Services:

Accounts Receivable –The Company was due $16,623 and $24,880 from MHI Hotels Services at June 30, 2012 and December 31, 2011, respectively.

Shell Island Sublease – The Company has a sublease arrangement with MHI Hotels Services on its expired leasehold interests in the property at Shell Island. Leasehold revenue for the three months and six months ended June 30, 2012 was $87,500 and $175,000, respectively, and was $160,000 and $320,000 for the three months and six months ended June 30, 2011, respectively. The leasehold interests expired on December 31, 2011.

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 hotels that the Company owned at June 30, 2012, except for the Crowne Plaza Tampa Westshore, are operated by MHI Hotels Services under a master management agreement that expires between December 2014 and April 2018. The Company entered into a separate management agreement with MHI Hotels Services for the management of the Crowne Plaza Tampa Westshore that expires in March 2019. Under both management agreements, 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 any hotel is 2.0% of gross revenues for the first full fiscal year and partial fiscal year from the commencement date through December 31 of that year, 2.5% of gross revenues the second full fiscal year, and 3.0% of gross revenues for every year thereafter. Pursuant to the sale of the Holiday Inn Downtown in Williamsburg, Virginia, one of the hotels initially contributed to the Company upon its formation, MHI Hotels Services agreed that the property in Jeffersonville, Indiana shall substitute for the Williamsburg property under the master management agreement. The incentive management fee, if any, is due annually in arrears within 90 days of the end of the fiscal year and will be equal to 10.0% 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.

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Base management fees earned by MHI Hotels Services totaled $749,282 and $1,344,953 for the three months and six months ended June 30, 2012, respectively, and $678,067and $1,216,623 for the three months and six months ended June 30, 2011, respectively. In addition, estimated incentive management fees of $62,415 and $112,053 were accrued for the three months and six months ended June 30, 2012, respectively, and estimated incentive management fees of $38,865 and $84,619 were accrued for the three months and six months ended June 30, 2011, respectively.

Employee Medical Benefits –The Company purchases employee medical benefits through Maryland Hospitality, Inc. (d/b/a MHI Health), an affiliate of MHI Hotels Services. Premiums for employee medical benefits paid by the Company were $592,983 and $1,220,888 for the three months and six months ended June 30, 2012, respectively and $625,984 and $1,268,305 for the three months and six months ended June 30, 2011, respectively.

10. Retirement Plan

The Company maintains a 401(k) plan for qualified employees which is subject to “safe harbor” provisions and which requires that the Company match 100% of the first 3% of employee contributions and 50% of the next 2% of employee contributions. All Company matching funds vest immediately in accordance with the “safe harbor” provision. Company contributions to the plan totaled $23,926 and $35,806 for the three months and six months ended June 30, 2012, respectively, and $20,466 and $31,553 for the three months and six months ended June 30, 2011, respectively.

11. Unconsolidated Joint Venture

The Company owns a 25.0% indirect interest in (i) the entity that owns the Crowne Plaza Hollywood Beach Resort; (ii) the entity that leases the hotel and has engaged MHI Hotels Services to operate the hotel under a management contract; (iii) the entity that had an option to purchase a three-acre development site with parking garage adjacent to the hotel and which leased the parking garage for use by the hotel; and (iv) the entity that owned the junior participation in the existing mortgage. Carlyle owns a 75.0% indirect controlling interest in all these entities. The joint venture purchased the property on August 8, 2007 and began operations on September 18, 2007. Summarized financial information for this investment, which is accounted for under the equity method, is as follows:

	June 30, 2012		December 31, 2011
	(unaudited)
ASSETS
Investment in hotel properties, net	$	66,933,850	$	67,682,291
Cash and cash equivalents		3,154,403		2,589,871
Accounts receivable		194,432		255,233
Prepaid expenses, inventory and other assets		2,076,406		2,059,130
TOTAL ASSETS	$	72,359,091	$	72,586,525
LIABILITIES
Mortgage loans, net	$	33,100,000	$	33,600,000
Accounts payable and other accrued liabilities		3,305,197		2,817,582
Advance deposits		376,046		301,952
TOTAL LIABILITIES		36,781,243		36,719,534
TOTAL MEMBERS’ EQUITY		35,577,848		35,866,991
TOTAL LIABILITIES AND MEMBERS’ EQUITY	$	72,359,091	$	72,586,525

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	Three months  ended June 30, 2012			Three months  ended June 30, 2011			Six months  ended June 30, 2012			Six months  ended June 30, 2011
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Revenue
Rooms department	$	3,041,078		$	2,892,060		$	7,463,159		$	6,678,598
Food and beverage department		569,025			722,008			1,355,163			1,446,162
Other operating departments		317,107			277,573			616,608			572,798
Total revenue		3,927,210			3,891,641			9,434,930			8,697,558
Expenses
Hotel operating expenses
Rooms department		702,300			655,863			1,482,667			1,337,321
Food and beverage department		480,479			520,174			1,064,924			1,030,084
Other operating departments		180,809			147,549			342,618			327,100
Indirect		1,648,539			1,734,199			3,475,831			3,061,409
Total hotel operating expenses		3,012,127			3,057,785			6,366,040			5,755,914
Depreciation and amortization		731,714			549,597			1,282,969			1,096,109
General and administrative		9,125			8,457			50,971			67,093
Total operating expenses		3,752,966			3,615,839			7,699,980			6,919,116
Net operating income		174,244			275,802			1,734,950			1,778,442
Interest expense		(436,780	)		(453,492	)		(875,584	)		(893,344	)
Unrealized loss on hedging activities		(89,785	)		(490,233	)		(148,509	)		(395,275	)
Net income (loss)	$	(352,321	)	$	(667,923	)	$	710,857		$	489,823

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12. Income Taxes

The components of the income tax provision for the three months and six months ended June 30, 2012 and 2011 are as follows (in thousands):

	Three months ended June 30, 2012		Three months ended June 30, 2011		Six months ended June 30, 2012			Six months ended June 30, 2011
	(unaudited)		(unaudited)		(unaudited)			(unaudited)
Current:
Federal	$	19	$	5	$	(49	)	$	14
State		8		1		8			56
		27		6		(41	)		70
Deferred:
Federal		791		667		869			644
State		140		115		235			123
		931		782		1,104			767
	$	958	$	788	$	1,063		$	837

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

	Three months ended June 30, 2012			Three months ended June 30, 2011		Six months ended June 30, 2012			Six months ended June 30, 2011
	(unaudited)			(unaudited)		(unaudited)			(unaudited)
Statutory federal income tax expense (benefit)	$	(404	)	$	185	$	(1,382	)	$	(253	)
Effect of non-taxable REIT income		1,214			487		2,202			911
State income tax expense (benefit)		148			116		243			179
	$	958		$	788	$	1,063		$	837

As of June 30, 2012 and December 31, 2011, the Company had a net deferred tax asset of approximately $3.0 million and $4.1 million, respectively, of which, approximately $2.4 million and $3.4 million, respectively, are due to accumulated net operating losses. These loss carryforwards will begin to expire in 2024 if not utilized by such time. As of June 30, 2012 and December 31, 2011, approximately $0.4 million of the net deferred tax asset is attributable to the Company’s share of start-up expenses related to the Crowne Plaza Hollywood Beach Resort, start-up expenses related to the opening of the Sheraton Louisville Riverside and the Crowne Plaza Tampa Westshore that were not deductible in the year incurred, but are being amortized over 15 years. The remainder of the net deferred tax asset is attributable to year-to-year timing differences including accrued, but not deductible, employee performance awards, vacation and sick pay, bad debt allowance and depreciation. The Company believes that it is more likely than not that the deferred tax asset will be realized and that no valuation allowance is required.

13. Earnings Per Share

The limited partners’ outstanding limited partnership units in the Operating Partnership (which may be redeemed for common stock upon notice from the limited partners and following the Company’s election to redeem the units for stock rather than cash) have been excluded from the diluted earnings per share calculation as there would be no effect on the amounts since the limited partners’ share of income would also be added back to net income. The computation of basic and diluted earnings per share is presented below.

	Three months ended June 30, 2012			Three months ended June 30, 2011			Six months ended June 30, 2012			Six months ended June 30, 2011
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Numerator
Net loss attributable to the Company for basic computation	$	(1,653,654	)	$	(182,563	)	$	(3,948,008	)	$	(1,171,881	)
Effect of the issuance of dilutive shares on the net loss attributable to the noncontrolling interest		(22,380	)		(23,130	)		(39,627	)		(23,130	)
Net loss attributable to the Company for dilutive computation	$	(1,676,034	)	$	(205,693	)	$	(3,987,635	)	$	(1,195,011	)

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	Three months ended June 30, 2012			Three months ended June 30, 2011			Six months  ended June 30, 2012			Six months  ended June 30, 2011
	(unaudited)			(unaudited)			(unaudited)			(unaudited)
Denominator
Weighted average number of common shares outstanding for basic computation		9,999,786			9,617,116			9,991,445			9,588,996
Dilutive effect of warrants		623,856			360,212			451,354			181,101
Weighted average number common shares outstanding for dilutive computation		10,623,642			9,977,328			10,442,799			9,770,097
Basic net loss per share	$	(0.17	)	$	(0.02	)	$	(0.40	)	$	(0.12	)
Diluted net loss per share	$	(0.16	)	$	(0.02	)	$	(0.38	)	$	(0.12	)

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

14. Subsequent Events

On July 10, 2012, the Company obtained a $14.3 million mortgage with Fifth Third Bank on the Crowne Plaza Jacksonville Riverfront in Jacksonville, Florida. The mortgage bears interest at a rate of LIBOR plus additional interest of 3.0% and amortizes on a 25-year schedule. The maturity date is July 10, 2015, but may be extended for an additional year pursuant to certain terms and conditions. The mortgage also contains an “earn-out” feature which allows for an additional draw of up to $3.0 million during the term of the loan contingent upon satisfaction of certain debt service coverage and loan-to-value requirements. Proceeds of the mortgage were used to repay the existing mortgage indebtedness and to pay closing costs.

On July 11, 2012, the Company paid a quarterly dividend (distribution) of $0.02 per common share (and unit) to those stockholders (and unitholders of MHI Hospitality, L.P.) of record on June 15, 2012.

On July 23, 2012, the Company authorized payment of a quarterly dividend (distribution) of $0.03 per common share (and unit) to those stockholders (and unitholders of MHI Hospitality, L.P.) of record as of September 14, 2012. The dividend (distribution) is to be paid on October 11, 2012.

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

Overview

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

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

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Property	Number of Rooms		Location	Date of Acquisition
Wholly-owned
Crowne Plaza Hampton Marina		173	Hampton, VA	April 24, 2008
Crowne Plaza Jacksonville Riverfront		292	Jacksonville, FL	July 22, 2005
Crowne Plaza Tampa Westshore		222	Tampa, FL	October 29, 2007
Doubletree by Hilton Brownstone-University		190	Raleigh, NC	December 21, 2004
Hilton Philadelphia Airport		331	Philadelphia, PA	December 21, 2004
Hilton Savannah DeSoto		246	Savannah, GA	December 21, 2004
Hilton Wilmington Riverside		272	Wilmington, NC	December 21, 2004
Holiday Inn Laurel West		207	Laurel, MD	December 21, 2004
Sheraton Louisville Riverside		180	Jeffersonville, IN	September 20, 2006
		2,113
Joint Venture Property
Crowne Plaza Hollywood Beach Resort		311	Hollywood, FL	August 9, 2007
Total		2,424

We conduct substantially all our business through our Operating Partnership. We are the sole general partner of our Operating Partnership, and we own an approximate 77.0% interest in our Operating Partnership, with the remaining interest being held by the contributors of our initial properties as limited partners.

To qualify as a REIT, we cannot operate hotels. Therefore, our Operating Partnership leases our wholly-owned hotel properties to MHI Hospitality TRS, LLC (our “TRS Lessee”), which then engages a hotel management company to operate the hotels under a management contract. Our TRS Lessee has engaged MHI Hotels Services to manage our hotels. Our TRS Lessee, and its parent, MHI Hospitality TRS Holding, Inc., are consolidated into our financial statements for accounting purposes. The earnings of MHI Hospitality TRS Holding, Inc. are subject to taxation similar to other C corporations.

Key Operating Metrics

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

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

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

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

Results of Operations

The following table illustrates the actual key operating metrics for each of the three months and six months ended June 30, 2012 and 2011 for the properties we wholly-owned during each respective reporting period.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Net Loss Attributable to the Company. The net loss attributable to the Company for the six months ended June 30, 2012 increased approximately $2.7 million to approximately $3.9 million as compared to a net loss of approximately $1.2 million for the six months ended June 30, 2011 as a result of the operating results discussed above.

Funds From Operations

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

Management believes that the use of FFO, combined with the required GAAP presentations, has improved the understanding of the operating results of REITs among the investing public and made comparisons of REIT operating results more meaningful. Management considers FFO to be a useful measure of adjusted net income for reviewing comparative operating and financial performance. Management believes FFO is most directly comparable to net income (loss), which remains the primary measure of performance, because by excluding gains or losses related to sales of previously depreciated operating real estate assets and excluding real estate asset depreciation and amortization, FFO assists in comparing the operating performance of a company’s real estate between periods or as compared to different companies. Although FFO is intended to be a REIT industry standard, other companies may not calculate FFO in the same manner as we do, and investors should not assume that FFO as reported by us is comparable to FFO as reported by other REITs.

The following table reconciles net loss to FFO for each of the three months and six months ended June 30, 2012 and 2011 (unaudited):

	Three months  ended June 30, 2012			Three months  ended June 30, 2011			Six months  ended June 30, 2012			Six months  ended June 30, 2011
Net loss	$	(2,146,312	)	$	(243,501	)	$	(5,126,655	)	$	(1,579,971	)
Add depreciation and amortization		2,195,591			2,149,910			4,375,554			4,273,387
Add equity in depreciation of joint venture		182,930			137,399			320,742			274,027
Subtract gain on disposal of assets		—			(6,055	)		—			(12,255	)
FFO	$	232,209		$	2,037,753		$	(430,359	)	$	2,955,188
Weighted average shares outstanding		9,999,786			9,617,116			9,991,445			9,588,996
Weighted average units outstanding		2,980,883			3,324,109			2,982,861			3,339,190
Weighted average shares and units		12,980,669			12,941,225			12,974,306			12,928,186
FFO per share and unit	$	0.02		$	0.16		$	(0.03	)	$	0.23

Sources and Uses of Cash

Operating Activities.Our principal source of cash to meet our operating requirements, including distributions to unitholders and stockholders as well as repayments of indebtedness, is the operations of our hotels. Cash flow provided by operating activities for the six months ended June 30, 2012 was approximately $5.0 million. We expect that the net cash provided by operations will be adequate to fund our continuing operations, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends in accordance with federal income tax laws which require us to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gains.

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

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

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

Capital Expenditures

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

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

Liquidity and Capital Resources

As of June 30, 2012, we had cash and cash equivalents of approximately $9.3 million, of which approximately $2.3 million was in restricted reserve accounts and real estate tax and insurance escrows. We expect that our cash on hand combined with our cash flow from our hotels should be adequate to fund continuing operations, recurring capital expenditures for the refurbishment and replacement of furniture, fixtures and equipment, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and dividends on the Preferred Stock.

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

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

In July 2012, we obtained a $14.3 million mortgage on the Crowne Plaza Jacksonville Riverfront. The maturity date is July 10, 2015, but may be extended for an additional year pursuant to certain terms and conditions. The mortgage contains an “earn-out” feature which allows us to draw up to an additional $3.0 million provided the property satisfies certain debt service coverage and loan-to-value requirements. Should we be able to draw the additional proceeds, we are required, under the terms of the Preferred Stock instrument, to use such proceeds to repurchase outstanding shares of Preferred Stock.

We will need to, and plan to, renew, replace or extend our long-term indebtedness prior to their respective maturity dates. We are uncertain whether we will be able to refinance these obligations or if refinancing terms will be favorable. If we are unable to obtain alternative or additional financing arrangements in the future, or if we cannot obtain financing on acceptable terms, we may be forced to dispose of hotel properties on disadvantageous terms. To the extent we cannot repay our outstanding debt, we risk losing some or all of these properties to foreclosure and we could be required to invoke insolvency proceedings including, but not limited to, commencing a voluntary case under the U.S. Bankruptcy Code.

We believe the recovering economy will provide opportunities to acquire properties at attractive prices. However, with the constraints of the covenants in our Preferred Stock instrument and Note Agreement, we have limited, if any, ability to incur additional debt in order to take advantage of such opportunities. Given the potential for attractive acquisitions emerging from the recent economic downturn, we intend to pursue additional joint venture transactions and equity financing in the future to enable us to take advantage of such opportunities. However, should additional joint venture transactions and equity financing not be available on acceptable terms, we may not be able to take advantage of such opportunities.

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Beyond the funding of any required principal reduction on our existing indebtedness or acquisitions in the near-term, our medium and long-term capital needs will generally include the retirement of maturing mortgage debt, redemption of the Preferred Stock, repayment of draws under the Bridge Financing, if any, and obligations under our tax indemnity agreements, if any. We remain committed to maintaining a flexible capital structure. Accordingly, we expect to meet our long-term liquidity needs through a combination of some or all the following:

• The issuance of additional shares of preferred stock;

• The issuance of additional shares of our common stock;

• The issuance of additional units in the Operating Partnership;

• The incurrence by the subsidiaries of the Operating Partnership of mortgage indebtedness in connection with the refinancing of hotel properties;

• The selective disposition of core or non-core assets;

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

• The issuance by the Operating Partnership and/or subsidiary entities of secured and unsecured debt securities to the extent permitted by our Preferred Stock instrument and Note Agreement; or

• The incurrence by the subsidiaries of the Operating Partnership of mortgage indebtedness in connection with the acquisition or refinancing of hotel properties.

Dividend Policy

In December 2008, in the interest of capital preservation and based on the expectation that the U.S. economy, and in particular the lodging industry, would continue to face declining operating trends through 2010, we amended our dividend policy and reduced the level of our cash dividend payments. Reducing and suspending our dividend during 2009 and 2010 did not jeopardize our REIT status as our 2009 distributions exceeded the minimum annual distribution requirement and operating losses in 2010 eliminated any distribution requirement for 2010.

In July 2011, in part due to improving operating trends, we reevaluated our quarterly dividend policy and reinstated our quarterly common stock dividend (distribution). On July 18, 2011, we authorized the first payment of a quarterly dividend (distribution) of $0.02 per common share (and unit) to our stockholders (and unitholders of MHI Hospitality, L.P.) of record as of September 15, 2011 which was paid on October 11, 2011. Dividends (distributions) have been declared in each subsequent quarterly period. In July 2012, we authorized an increase in the quarterly dividend (distribution) to $0.03 per common share (and unit).

Our ability to make common stock distributions is constrained by the terms of the Preferred Stock instrument and the Note Agreement. The Preferred Stock instrument and the Note Agreement permit us to pay a dividend on our common stock subject to certain requirements, including liquidity thresholds. At present, we meet and exceed these requirements to pay a dividend on our common stock in an amount minimally necessary in order to maintain our status as a REIT. The Preferred Stock instrument requires a minimum liquidity position of $7.5 million as a condition to payment of a dividend on common stock. The Note Agreement further provides that we may make additional dividend distributions if we have, and will have after giving effect to such distributions, at least $10.0 million in total cash or cash equivalents. Up to $5.0 million in undrawn commitments under the Note Agreement may be included in calculating the liquidity requirements under the Preferred Stock instrument and the Note Agreement.

The amount of future common stock distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Code’s annual distribution requirements, the terms of our Preferred Stock instrument and Note Agreement, and other factors, which our board of directors deems relevant. The amount, timing and frequency of distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors, and no assurance can be given that our distribution policy will not change in the future.

The holders of the Preferred Stock have a right to payment of a cumulative dividend payable quarterly (i) in cash at an annual rate of 10.0% of the liquidation preference per share and (ii) in additional shares of the preferred stock at an annual rate of 2.0% of the $1,000 liquidation preference per share.

Off-Balance Sheet Arrangements

Through a joint venture with a Carlyle subsidiary, we own a 25.0% indirect, noncontrolling interest in an entity (the “JV Owner”) that acquired the 311-room Crowne Plaza Hollywood Beach Resort in Hollywood, Florida. We have the right to receive a pro rata share of operating surpluses and we have an obligation to fund our pro rata share of operating shortfalls. We also have the opportunity to earn an incentive participation in the net proceeds realized from the sale of the hotel based upon the achievement of certain overall investment returns, in addition to our pro rata share of net sale proceeds. The Crowne Plaza Hollywood Beach Resort is leased to another entity (the “Joint Venture Lessee”) in which we also own a 25.0% indirect, noncontrolling interest.

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The acquisition of the property was funded in part by a mortgage loan in the amount of $57.6 million. The mortgage, which had an original two-year term maturing on August 1, 2009, was restructured on June 13, 2008 so that the first $35.6 million bore interest at a rate of LIBOR plus additional interest of 0.98%. The remaining $22.0 million bore a rate of LIBOR plus additional interest of 3.50%. Upon that restructure, a fourth entity, in which we own a 25.0% indirect noncontrolling interest, purchased the $22.0 million junior participation for $19.0 million. The loan had been extended for one year and was modified in August 2010 to extend the maturity date to August 2014, require monthly payments of interest at a rate of LIBOR plus additional interest of 1.94% and require annual principal payments of $0.5 million. In conjunction with the loan modification, the joint venture made an additional $1.5 million payment of principal and executed an interest-rate swap with a notional amount and maturity tied to the projected outstanding balance and maturity date of the loan. The Crowne Plaza Hollywood Beach Resort secures the mortgage. We have provided limited guarantees to the lender with respect to this mortgage.

Carlyle owns a 75.0% controlling interest in the JV Owner, the Joint Venture Lessee, the entity with the purchase option and the entity that held the junior participation. Carlyle may elect to dispose of the Crowne Plaza Hollywood Beach Resort without our consent. We account for our noncontrolling 25.0% interest in all of these entities under the equity method of accounting.

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.

Our expenses, including hotel operating expenses, administrative expenses, real estate taxes and property and casualty insurance are subject to inflation. These expenses are expected to grow with the general rate of inflation, except for energy, liability insurance, property and casualty insurance, property tax rates, employee benefits, and some wages, which are expected to increase at rates higher than inflation.

Seasonality

The operations of our hotel properties have historically been seasonal. The months of April and May are traditionally strong, as is October. The periods from mid-November through mid-February are traditionally slow with the exception of the Crowne Plaza Jacksonville Hotel, the Crowne Plaza Tampa Westshore and our joint venture property, the Crowne Plaza Hollywood Beach Resort. The remaining months are generally good, but can be impacted by bad weather and can vary significantly.

Geographic Concentration

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

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 to 39 years for buildings and improvements and 3 to 10 years for furniture and equipment. In accordance with generally accepted accounting principles, the controlling interests in hotels comprising our accounting predecessor, MHI Hotels Services Group, and noncontrolling interests held by the controlling holders of our accounting predecessor in hotels acquired from third parties are recorded at historical cost basis. Noncontrolling 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.

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There were no charges for impairment recorded for the three months and six months ended June 30, 2012 or 2011.

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, 2012. 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.

Recent Accounting Pronouncements

For a summary of recently adopted and newly issued accounting pronouncements, please refer to theRecent Accounting Pronouncementssection of Note 2,Summary of Significant Accounting Policies, in the Notes to Financial Statements.

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 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:

• national and local economic and business conditions, including recessionary economic conditions existing over the last several years, that affect occupancy rates at the Company’s hotels and the demand for hotel products and services;

• risks associated with the hotel industry, including competition, increases in wages, energy costs and other operating costs;

• the magnitude, sustainability and timing of the economic recovery in the hospitality industry and in the markets in which the Company operates;

• the availability and terms of financing and capital and the general volatility of the securities markets, specifically, the impact of the recent credit crisis which has severely constrained the availability of debt financing;

• risks associated with the level of the Company’s indebtedness and its ability to meet covenants in its debt agreements and, if necessary, to refinance the maturity of such indebtedness or modify such debt agreements;

• management and performance of the Company’s hotels;

• risks associated with the conflicts of interest of the Company’s officers and directors;

• risks associated with redevelopment and repositioning projects, including delays and cost overruns;

• supply and demand for hotel rooms in the Company’s current and proposed market areas;

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

• the Company’s ability to successfully expand into new markets;

• legislative/regulatory changes, including changes to laws governing taxation of REITs;

• the Company’s ability to maintain its qualification as a REIT; and

• the Company’s ability to maintain adequate insurance coverage.

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 Annual Report on Form 10-K and subsequent reports filed with the Securities and Exchange Commission.

These risks and uncertainties 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 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 could 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. In August 2006, we purchased an interest-rate swap with a notional amount of $30.0 million in order to comply with the terms of our then-existing credit agreement which required us to hedge a portion of the maximum borrowing amount. In June 2010, we replaced the interest-rate swap with another interest-rate swap with a notional amount of $30.0 million which expired in May 2011. 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 derivative contracts for trading or speculative purposes.

As of June 30, 2012, we had approximately $113.4 million of fixed-rate debt and approximately $42.1 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 6.92%. 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. Our variable-rate debt is exposed to changes in interest rates, specifically the change in 30-day LIBOR, but would be limited to the effect on our mortgage on the Crowne Plaza Hampton Marina – to the extent that 30-day LIBOR exceeds 0.45%, the loan on the Hilton Philadelphia Airport – to the extent that 30-day LIBOR exceeds 0.50% – as well as the loan from the Carlyle Affiliate Lender. Assuming that the amount outstanding on our mortgage on the Crowne Plaza Hampton Marina, the mortgage on the Hilton Philadelphia Airport and the loan from the Carlyle Affiliate Lender remain at approximately $42.4 million, the balance at June 30, 2012, the impact on our annual interest incurred and cash flows of a one percent increase in 30-day LIBOR would be approximately $328,000.

As of December 31, 2011, we had approximately $116.4 million of fixed-rate debt and approximately $38.0 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 7.66%. 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. Our variable-rate debt is exposed to changes in interest rates, specifically the change in 30-day LIBOR, but would be limited to the effect on our mortgage on the Crowne Plaza Hampton Marina – to the extent that 30-day LIBOR exceeds 0.45% – as well as the loan from the Carlyle Affiliate Lender and the balance on the then-existing credit facility. Assuming that the amount outstanding on our mortgage on the Crowne Plaza Hampton Marina, the loan from the Carlyle Affiliate Lender and the amount outstanding under our then-existing credit facility remain at approximately $38.0 million, the balance at December 31, 2011, the impact on our annual interest incurred and cash flows of a one percent increase in 30-day LIBOR would be approximately $367,000.

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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.

As of June 30, 2012, 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 legal proceedings other than routine legal proceedings occurring in the ordinary course of business. We believe that these routine legal proceedings, in the aggregate, are not material to our financial condition and results of operations.

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, 2011 and our quarterly report on Form 10-Q for the quarterly period ended March 31, 2012.

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

Not applicable.

Item 3.Defaults Upon Senior Securities

Not applicable.

Item 4.Mine Safety Disclosures

Not applicable.

Item 5.Other Information

Not applicable.

Item 6.Exhibits

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

Exhibit Number	Description of Exhibit
3.1	Articles of Amendment and Restatement of MHI Hospitality Corporation.(1)
3.4	Articles Supplementary of MHI Hospitality Corporation.(2)
3.5	Amended and Restated Bylaws of MHI Hospitality Corporation. (2)
10.40	Amendment No. 2, dated June 15, 2012, to Note Agreement, dated April 18, 2011, by and between the Company and Essex Equity High Income Joint Investment Vehicle, LLC. (3)
10.41	Agreement, Waiver and Consent by Preferred Stockholders, dated June 15, 2012, by and among the Company, Essex Illiquid, LLC, and Richmond Hill Capital Partners, LP. (3)
31.1	Certification of 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 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.

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Exhibit Number	Description of Exhibit
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

(1) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004. (333-118873).

(2) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011.

(3) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on June 20, 2012.

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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 9, 2012	By:	/s/ Andrew M. Sims
		Andrew M. Sims
		Chief Executive Officer
	By:	/s/ William J. Zaiser
		William J. Zaiser
		Chief Financial Officer

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EXHIBIT INDEX

Exhibit Number	Description of Exhibit
3.1	Articles of Amendment and Restatement of MHI Hospitality Corporation.(1)
3.4	Articles Supplementary of MHI Hospitality Corporation.(2)
3.5	Amended and Restated Bylaws of MHI Hospitality Corporation. (2)
10.40	Amendment No. 2, dated June 15, 2012, to Note Agreement, dated April 18, 2011, by and between the Company and Essex Equity High Income Joint Investment Vehicle, LLC. (3)
10.41	Agreement, Waiver and Consent by Preferred Stockholders, dated June 15, 2012, by and among the Company, Essex Illiquid, LLC, and Richmond Hill Capital Partners, LP. (3)
31.1	Certification of 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 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.
101.INS	XBRL Instance Document
101.SCH	XBRL Taxonomy Extension Schema Document
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document
101.LAB	XBRL Taxonomy Extension Label Linkbase Document
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document

(1) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Pre-Effective Amendment No. 1 to its Registration Statement on Form S-11 filed with the Securities and Exchange Commission on October 20, 2004. (333-118873).

(2) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on April 18, 2011.

(3) Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Registrant’s Current Report on Form 8-K filed with the Securities and Exchange Commission on June 20, 2012.

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