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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended September 30, 2011

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 W. 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 November 9, 2011, there were 9,766,786 shares of the registrant’s common stock issued and outstanding.

 

 

 

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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			19
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			28
Item 4		Controls and Procedures			29
		PART II
Item 1.		Legal Proceedings			30
Item 1A.		Risk Factors			30
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			30
Item 3.		Defaults Upon Senior Securities			30
Item 4.		Removed and Reserved			30
Item 5.		Other Information			30
Item 6.		Exhibits			30

 

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PART I

 

Item 1.

Financial Statements

MHI HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

 

		September 30, 2011				December 31, 2010
		(unaudited)
ASSETS
Investment in hotel properties, net		$	182,002,524			$	183,898,660
Investment in joint venture			9,115,806				9,464,389
Cash and cash equivalents			5,399,225				2,992,888
Restricted cash			3,554,450				2,205,721
Accounts receivable			2,528,793				1,868,380
Accounts receivable-affiliate			—				17,375
Prepaid expenses, inventory and other assets			1,923,747				2,335,783
Notes receivable, net			100,000				100,000
Shell Island lease purchase, net			810,662				1,080,882
Deferred income taxes			4,055,457				4,742,695
Deferred financing costs, net			3,106,362				872,415
TOTAL ASSETS		$	212,597,026			$	209,583,431
LIABILITIES
Line of credit		$	45,133,013			$	75,197,858
Mortgage debt			75,029,937				72,192,253
Series A Cumulative Redeemable Preferred Stock, par value $0.01, 27,650 shares authorized, 25,227 and 0 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively			25,226,530				—
Loans payable			8,400,220				4,493,970
Accounts payable and accrued liabilities			8,901,659				6,335,145
Advance deposits			725,955				555,902
Dividends and distributions payable			258,825				—
Accounts payable – affiliate			3,351				—
Warrant derivative liability			1,368,000				—
TOTAL LIABILITIES			165,047,490				158,775,128
Commitments and contingencies (see Note 6)
EQUITY
MHI Hospitality Corporation stockholders’ equity
Preferred stock, par value $0.01; 972,350 shares authorized, 0 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively			—				—
Common stock, par value $0.01, 49,000,000 shares authorized, 9,701,786 shares and 9,541,286 shares issued and outstanding at September 30, 2011 and December 31, 2010, respectively			97,018				95,413
Additional paid in capital			56,195,576				55,682,976
Distributions in excess of retained earnings			(19,320,142	)			(16,837,182	)
Total MHI Hospitality Corporation stockholders’ equity			36,972,452				38,941,207
Noncontrolling interest			10,577,084				11,867,096
TOTAL EQUITY			47,549,536				50,808,303
TOTAL LIABILITIES AND EQUITY		$	212,597,026			$	209,583,431

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

 

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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

 

		Three months  ended September 30, 2011				Three months  ended September 30, 2010				Nine months  ended September 30, 2011				Nine months  ended September 30, 2010
REVENUE
Rooms department		$	14,154,271			$	13,736,101			$	43,223,226			$	40,784,193
Food and beverage department			4,656,014				4,657,257				14,991,087				14,395,240
Other operating departments			1,204,901				1,144,373				3,466,164				3,383,410
Total revenue			20,015,186				19,537,731				61,680,477				58,562,843
EXPENSES
Hotel operating expenses
Rooms department			4,078,235				3,972,346				12,048,335				11,495,313
Food and beverage department			3,266,031				3,227,304				10,102,863				9,756,741
Other operating departments			157,839				196,410				420,580				540,248
Indirect			8,152,905				7,770,926				23,942,063				22,610,861
Total hotel operating expenses			15,655,010				15,166,986				46,513,841				44,403,163
Depreciation and amortization			2,187,541				2,123,761				6,460,928				6,381,378
Corporate general and administrative			1,348,792				725,909				3,154,412				2,687,719
Total operating expenses			19,191,343				18,016,656				56,129,181				53,472,260
NET OPERATING INCOME			823,843				1,521,075				5,551,296				5,090,583
Other income (expense)
Interest expense			(2,747,284	)			(2,608,276	)			(8,052,832	)			(7,385,350	)
Interest income			4,281				4,843				11,819				15,779
Equity income (loss) in joint venture			(283,539	)			(184,237	)			(161,083	)			5,089
Unrealized gain on warrant derivative			646,000				—				266,000				—
Unrealized gain (loss) on hedging activities			—				(16,566	)			72,649				630,828
Gain (loss) on disposal of assets			(9,894	)			(84,128	)			2,361				(84,128	)
Net loss before income taxes			(1,566,593	)			(1,367,289	)			(2,309,790	)			(1,727,199	)
Income tax benefit (provision)			71,692				(3,461	)			(765,083	)			(365,861	)
Net loss			(1,494,901	)			(1,370,750	)			(3,074,873	)			(2,093,060	)
Add: Net loss attributable to the noncontrolling interest			377,859				366,400				785,948				564,435
NET LOSS ATTRIBUTABLE TO THE COMPANY		$	(1,117,042	)		$	(1,004,350	)		$	(2,288,925	)		$	(1,528,625	)
Net loss per share attributable to the Company
Basic		$	(0.12	)		$	(0.11	)		$	(0.24	)		$	(0.16	)
Diluted		$	(0.11	)		$	(0.11	)		$	(0.23	)		$	(0.16	)
Weighted average number of shares outstanding
Basic			9,701,786				9,541,286				9,627,006				9,415,593
Diluted			9,802,378				9,557,286				9,792,440				9,431,593

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

 

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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, 2010			9,541,286			$	95,413			$	55,682,976			$	(16,837,182	)		$	11,867,096			$	50,808,303
Issuance of restricted common stock awards			45,500				455				74,475				—				—				74,930
Conversion of units in operating partnership			115,000				1,150				438,125				—				(439,275	)			—
Dividends and distributions declared			—				—				—				(194,035	)			(64,789	)			(258,824	)
Net loss			—				—				—				(2,288,925	)			(785,948	)			(3,074,873	)
Balances at September 30, 2011			9,701,786			$	97,018			$	56,195,576			$	(19,320,142	)		$	10,577,084			$	47,549,536

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

 

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MHI HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

		Nine months  ended September 30, 2011				Nine months  ended September 30, 2010
Cash flows from operating activities:
Net loss		$	(3,074,873	)		$	(2,093,060	)
Adjustments to reconcile net loss attributable to the Company to net cash provided by operating activities:
Depreciation and amortization			6,460,928				6,381,378
Equity (income) loss in joint venture			161,083				(5,089	)
Unrealized (gain)loss on derivatives			(338,649	)			(630,828	)
(Gain) loss on disposal of assets			(2,361	)			84,128
Amortization of deferred financing costs			893,537				871,506
Paid-in-kind interest			226,530				—
Charges related to equity-based compensation			74,930				226,126
Changes in assets and liabilities:
Restricted cash			(123,602	)			(692,151	)
Accounts receivable			(660,413	)			(1,204,259	)
Prepaid expenses, inventory and other assets			353,800				(567,234	)
Deferred income taxes			691,481				327,919
Accounts payable and accrued liabilities			2,559,821				1,306,279
Advance deposits			170,053				309,113
Due from affiliates			20,725				26,662
Net cash provided by operating activities			7,412,990				4,340,490
Cash flows from investing activities:
Improvements and additions to hotel properties			(4,181,335	)			(2,211,195	)
Proceeds from sale of furniture and equipment			26,705				—
Distributions from joint venture			187,500				138,386
Funding of restricted cash reserves			(1,742,175	)			(1,359,144	)
Proceeds of restricted cash reserves			1,267,048				597,518
Net cash used in investing activities			(4,442,257	)			(2,834,435	)
Cash flows from financing activities:
Proceeds of cumulative mandatorily redeemable preferred stock and warrant			25,000,000				—
Proceeds of mortgage debt			7,500,000				—
Proceeds of loans			4,000,000				—
Payments on credit facility			(30,064,845	)			(325,000	)
Pledge of cash collateral			(750,000	)			—
Redemption of units in Operating Partnership			—				(17,600	)
Payment of deferred financing costs			(1,493,484	)			(530,595	)
Payments of mortgage debt and loans			(4,756,067	)			(376,875	)
Net cash used in financing activities			(564,396	)			(1,250,070	)
Net increase in cash and cash equivalents			2,406,337				255,985
Cash and cash equivalents at the beginning of the period			2,992,888				3,490,487
Cash and cash equivalents at the end of the period		$	5,399,225			$	3,746,472
Supplemental disclosures:
Cash paid during the period for interest		$	6,277,147			$	6,584,127
Cash paid during the period for income taxes		$	46,655			$	19,625
Non-cash investing and financing activities:
Issuance of warrant with cumulative mandatorily redeemable preferred stock		$	1,634,000			$	—

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

 

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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% non-controlling 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 September 30, 2011, was approximately 75.0% 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:

Amendments to Credit Agreement – On June 4, 2010, the Company entered into a fifth amendment to its credit agreement to address the sufficiency of the borrowing base. The amendment revises the methodology used to value the Company’s existing hotel properties in the borrowing base and modifies certain other aspects of the credit agreement, as amended, including fixing the interest rate spread for the variable LIBOR-based interest rate at 4.00% and a minimum LIBOR of 0.75%. The amendment converts the facility to non-revolving, eliminates the Company’s ability to re-borrow principal paid in the future and establishes minimum repayments equal to 50% of excess cash flow, as defined in the agreement, payable quarterly. Pursuant to the amendment, the Company is required to fund reserves for insurance and real estate taxes as well as a reserve for the replacement of furniture, fixtures and equipment equal to 3.0% of gross room revenues. The amendment also modifies the fixed charge covenant, eliminates the leverage covenant, places limits on capital expenditures and requires prepayments from a portion of the proceeds of future equity offerings of up to $21.7 million. In the event that the Company makes prepayments totaling $21.7 million, the excess cash flow prepayment requirement will terminate. The amendment allows the Company to pay additional dividends in any fiscal quarter, subject to the existing cap of 90% of the prior year’s funds from operations (“FFO”) provided certain liquidity thresholds and other conditions are met. The amendment provides for a contingent extension of the maturity date for one year to May 2012, provided that certain valuation and other criteria are met, including payment of an extension fee and an extension or refinancing of the Jacksonville mortgage.

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

Sale of Preferred Stock and Warrant – On April 18, 2011, the Company entered into a Securities Purchase Agreement (the “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.

 

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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 has the right to borrow up to $10.0 million on or before December 31, 2011 (the “Bridge Financing”). The principal amount borrowed will bear 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.

Mortgage Loan Extension – 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.

Mortgage Loan Refinancing – 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.

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 credit facility.

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 September 30, 2011 and December 31, 2010 and for the three months and nine months ended September 30, 2011 and 2010. 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.

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 non-controlling 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 entered into a lease agreement upon closing of the hotel acquisition with respect to the adjacent three-acre site on which is located a parking garage that is utilized by the hotel; and (iv) the entity that owned the 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 net sale proceeds based upon the achievement of certain overall investment returns, in addition to its pro rata share of net sale proceeds.

 

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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 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, reserves for replacements of furniture, fixtures and equipment as well as cash collateral accounts maintained with its lenders or lenders’ agents 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 September 30, 2011 and December 31, 2010 were $296,240 and $331,002, respectively. Amortization expense for the three months and nine months ended September 30, 2011 totaled $11,587 and $34,763, respectively, and $12,187 and $36,562, respectively, for the three months and nine months ended September 30, 2010.

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 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
September 30, 2011
Interest-rate swap		$	—			$	—			$	—
Warrant			—				(1,368,000	)			—
December 31, 2010
Interest-rate swap			—				(72,649	)			—
Warrant			—				—				—

 

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The Company’s interest-rate swap liability is valued by discounting expected future cash flows based on quoted prices for forward interest-rate contracts.

The warrant derivative liability was valued at September 30, 2011 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 0.97%, a dividend yield of 5.00%, expected volatility of 68.0% and a remaining term of approximately 5 years.

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.

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 September 30, 2011, 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, 2010 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 215,938 shares including 165,935 shares issued to certain executives and employees, and 50,000 restricted shares issued to its independent directors. Of the 165,935 shares issued to certain of the Company’s executives and employees, all have vested except 14,000 shares issued to the Vice President and General Counsel upon execution of his employment contract which will vest in equal amounts of 7,000 shares on each anniversary of the effective date of his employment agreement over the next two-year period. Regarding the restricted shares awarded to the Company’s independent directors, all of the shares have vested except 12,000 shares which vest at the end of 2011.

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 September 30, 2011, 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 $11,698 and $35,093, respectively, for the three months and nine months ended September 30, 2011 and $46,418 and $132,337, respectively for the three months and nine months ended September 30, 2010.

 

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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 three months or nine months ended September 30, 2011.

4. Investment in Hotel Properties

Investment in hotel properties as of September 30, 2011 and December 31, 2010 consisted of the following (in thousands):

 

		September 30, 2011				December 31, 2010
		(unaudited)
Land and land improvements		$	19,258			$	19,245
Buildings and improvements			178,852				176,641
Furniture, fixtures and equipment			31,788				30,345
			229,898				226,231
Less: accumulated depreciation			(47,895	)			(42,332	)
		$	182,003			$	183,899

5. Debt

Credit Facility. As of September 30, 2011, 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.

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%. The amendment established a LIBOR floor of 0.75%; converted it to a non-revolving facility; eliminated a fee of 0.25% on the unused portion of the facility; instituted a provision for mandatory quarterly pre-payments based on excess cash flow, as defined in the amendment, as well as a provision for 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) extends the final maturity date of advances under the credit agreement to May 8, 2014; (ii) provides that no additional advances may be made and no currently outstanding advances subsequently repaid or prepaid may be re-borrowed; (iii) adjusts the release amounts with respect to secured hotel properties; (iv) reduces the additional interest from 4.00% to 3.50% and removes the LIBOR floor of 0.75%; and (v) adjusts certain financial covenants including restrictions relating to payment of dividends. In connection with the amendment, the Company reduced the outstanding balance on its existing credit facility by approximately $22.7 million.

The Company had borrowings under the credit facility of approximately $45.1 million and approximately $75.2 million at September 30, 2011 and December 31, 2010, respectively.

At September 30, 2011, the credit facility was secured by the Holiday Inn Brownstone in Raleigh, North Carolina, the Hilton Philadelphia Airport, the Sheraton Louisville Riverside and the Crowne Plaza Tampa Westshore, as well as a lien on all business assets of those properties including, but not limited to, equipment, accounts receivable, inventory, furniture, fixtures and proceeds thereof. At September 30, 2011, the four properties had a net carrying value of approximately $93.1 million. Under the terms of the credit agreement, the Company must satisfy certain financial and non-financial covenants. The Company was in compliance with all required covenants as of September 30, 2011.

Mortgage Debt. As of September 30, 2011, the Company had approximately $75.0 million of outstanding mortgage debt. 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
		September 30, 2011				December 31, 2010
Crowne Plaza Hampton Marina		$	8,949,625			$	9,000,000				N				06/2012			$	16,000	(1)			LIBOR plus  4.55	%(2)
Crowne Plaza Jacksonville Riverfront			14,000,000				18,000,000				N				01/2013	(3)			Interest  Only	(3)			8.00	%
Hilton Savannah DeSoto			22,594,245				22,867,464					(4)			07/2017				25 years	(5)			6.06	%
Hilton Wilmington Riverside			21,997,447				22,324,789					(4)			03/2017				25 years	(6)			6.21	%
Holiday Inn Laurel West			7,488,620				—					(7)			08/2021				25 years				5.25	%(8)
Total		$	75,029,937			$	72,192,253

 

(1)	The Company is required to make monthly principal payments of $16,000.

(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 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.

(5)	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.

(6)	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.

(7)	The note provides for pre-payment penalties during the first through fourth years and sixth through ninth years of the term of the mortgage.

(8)	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%.

Total mortgage debt maturities as of September 30, 2011 without respect to any additional loan extensions or modification subsequent to September 30, 2011 for the following twelve-month periods were as follows:

 

September 30, 2012		$	9,988,793
September 30, 2013			15,104,620
September 30, 2014			1,173,013
September 30, 2015			1,245,652
September 30, 2016			1,321,786
Thereafter			46,196,073
Total future maturities		$	75,029,937

Loan from Carlyle Affiliate Lender. 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 September 30, 2011 and December 31, 2010 was $4,400,220 and $4,493,970, 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 has 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. The principal amount borrowed will bear interest at the rate of 9.25% per

 

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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 which do not secure the Company’s obligations under the Company’s credit agreement 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. At September 30, 2011, the Company had borrowings under the Bridge Financing of $4.0 million.

6. 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 five optional five-year periods expiring October 31, 2011, October 31, 2016, October 31, 2021, October 31, 2026 and October 31, 2031, respectively. Rent expense for the three months and nine months ended September 30, 2011 totaled $16,215 and $49,640, respectively, and totaled $14,251 and $44,530 for the three months and nine months ended September 30, 2010, 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 Holiday Inn Brownstone in Raleigh, North Carolina. The land is leased under a second amendment, dated April 28, 1998, to a ground lease originally dated May 25, 1966. The original lease is a 50-year operating lease, which expires August 31, 2016. There is a renewal option for up to three additional ten-year periods expiring August 31, 2026, August 31, 2036, and August 31, 2046, respectively. The Company holds an exclusive and irrevocable option to purchase the leased land at fair market value at the end of the original lease term, subject to the payment of an annual fee of $9,000, and other conditions. Rent expense for the three months and nine months ended September 30, 2011 totaled $23,871 and $71,612, respectively, and totaled $23,871 and $71,612 for the three months and nine months ended September 30, 2010, respectively.

In conjunction with the sublease arrangement for the property at Shell Island, the Company incurs an annual lease expense for a leasehold interest other than the purchased leasehold interest. Lease expense totaled $48,750 and $146,250 for the three months and nine months ended September 30, 2011, respectively and totaled $48,750 and $146,250 for the three months and nine months ended September 30, 2010, respectively.

The Company leases a parking lot in close proximity to the Sheraton Louisville Riverside. The land is leased under an agreement dated August 17, 2007 with the City of Jeffersonville, which in turn leases the property from the State of Indiana. The lease term for the parking lot coincides with that of the lease with the State of Indiana, which expires December 31, 2011. The Company has the right to renew or extend the lease with the City of Jeffersonville pursuant to the conditions of the original lease provided that the City of Jeffersonville is able to renew or extend the underlying lease with the State of Indiana. Rent expense totaled $8,400 and $25,200 for the three months and nine months ended September 30, 2011, respectively, and totaled $8,400 and $25,200 for the three months and nine months ended September 30, 2010, 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 $700 and $2,116 for the three months and nine months ended September 30, 2011, respectively, and totaled $608 and $1,824 for the three months and nine months ended September 30, 2010, 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 $3,720 for the three months and nine months ended September 30, 2011, respectively, and totaled $1,240 and $3,720 for the three months and nine months ended September 30, 2010, 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 $41,250 for the three months and nine months ended September 30, 2011, respectively, and totaled $13,750 and $41,250 for the three months and nine months ended September 30, 2010, respectively.

 

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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 $11,046 and $33,274 for the three months and nine months ended September 30, 2011, respectively, and totaled $11,013 and $33,039 for the three months and nine months ended September 30, 2010, respectively.

The Company also leases certain furniture and equipment under financing arrangements expiring between October 2011 and March 2014.

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

 

September 30, 2012		$	500,559
September 30, 2013			653,720
September 30, 2014			496,601
September 30, 2015			268,899
September 30, 2016			211,467
Thereafter			27,888
Total future minimum lease payments		$	2,159,134

Management Agreements – Each of the operating hotels that the Company wholly-owned at September 30, 2011, 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 September 30, 2011, 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 November 2011 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 to establish a property improvement fund for each of these two hotels to cover the cost of replacing capital assets at the properties. Each month, contributions to the property improvement fund equal 4.0% of gross revenues for the Hilton Savannah DeSoto and the Hilton Wilmington Riverside.

Pursuant to the terms of the mortgage on the Crowne Plaza Jacksonville Riverfront, the Company is required to make monthly contributions equal to 4.0% of room revenues into a property improvement fund.

Pursuant to the terms of the mortgage on the Crowne Plaza Hampton Marina, the Company is required to make monthly contributions equal to 4.0% of gross revenues to a property improvement fund.

Pursuant to the terms of the fifth amendment to the credit agreement, the Company is 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 is 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.

7. 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

 

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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. As of September 30, 2011, there were approximately 25,227 shares of the Preferred Stock issued and outstanding. 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.

The Warrant entitles the holder(s) to purchase up to 1,900,000 shares of the Company’s common stock at an exercise price of $2.25 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 adjustment 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.

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 Stock – 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 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.

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 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 June 7, 2010, the Company issued 21,000 shares of restricted stock to its Vice President and General Counsel in accordance with the terms of his employment contract.

On March 22, 2010, one holder of units in the Operating Partnership redeemed 368,168 units for an equivalent number of shares of the Company’s common stock.

During February 2010, the Company issued 18,175 shares of non-restricted stock to certain executives and 12,000 shares of restricted stock to its independent directors.

In addition, on February 1, 2010, the Company issued 15,000 shares of non-restricted stock to its Chief Executive Officer in accordance with the terms of his renewed employment contract.

As of September 30, 2011 and December 31, 2010, the Company had 9,701,786 and 9,541,286 shares of common stock outstanding, respectively.

Warrants – As of September 30, 2011, the Company has granted no warrants representing the right to purchase common stock other than the Warrant described in Note 7.

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.

 

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As of September 30, 2011, the total number of Operating Partnership units outstanding was 3,239,439, with a fair market value of approximately $7.0 million based on the price per share of the common stock on that date.

9. Related Party Transactions

As of September 30, 2011, 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, a current member and a former member of its Board of Directors) owned approximately 8.3% of the Company’s outstanding common stock and 2,103,670 Operating Partnership units. The following is a summary of the transactions between the Company and MHI Hotels Services:

Accounts Receivable – At September 30, 2011, and December 31, 2010, the Company owed $3,351 and was due $17,375, respectively, from MHI Hotels Services.

Shell Island Sublease – The Company has a sublease arrangement with MHI Hotels Services on its leasehold interests in the property at Shell Island. Leasehold revenue for each of the three months and nine months ended September 30, 2011 and 2010 was $160,000 and $480,000, respectively.

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

Management Agreements – Each of the hotels that the Company owned at September 30, 2011, 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.

Management fees earned by MHI Hotels Services totaled $582,737 and $1,799,360 for the three months and nine months ended September 30, 2011, respectively, and $502,397 and $1,494,556 for the three months and nine months ended September 30, 2010, respectively. In addition, estimated incentive management fees of $(16,188) and $68,431 were accrued for the three months and nine months ended September 30, 2011, respectively, and estimated management fees of $36,263 and $42,358 were accrued for the three months and nine months ended September 30, 2010, 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 $608,502 and $1,876,807 for the three months and nine months ended September 30, 2011, respectively and $617,763 and $1,593,923 for the three months ended September 30, 2010, respectively.

Construction Management Services – The Company has engaged MHI Hotels Services to manage certain aspects of the renovations at the Crowne Plaza Tampa Westshore and the Holiday Inn Brownstone. The Company paid no construction management fees for the three months and nine months ended September 30, 2011 and $66,667 and $141,733 for the three months and nine months ended September 30, 2010, 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 $9,440 and $40,994 for the three months and nine months ended September 30, 2011, respectively, and $16,434 and $37,396 for the three months and nine months ended September 30, 2010, respectively.

 

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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 entered into a lease agreement upon closing of the hotel acquisition with respect to the adjacent three-acre site on which is located a parking garage that is utilized 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:

 

		September 30, 2011				December 31, 2010
		(unaudited)
ASSETS
Investment in hotel properties, net		$	68,221,019			$	69,678,303
Cash and cash equivalents			3,204,574				1,952,687
Accounts receivable			98,141				271,822
Prepaid expenses, inventory and other assets			2,329,363				2,772,382
TOTAL ASSETS		$	73,853,097			$	74,675,194
LIABILITIES
Mortgage loans, net		$	33,600,000			$	34,100,000
Accounts payable and other accrued liabilities			3,342,106				2,434,683
Advance deposits			447,958				283,144
TOTAL LIABILITIES			37,390,064				36,817,827
TOTAL MEMBERS’ EQUITY			36,463,033				37,857,367
TOTAL LIABILITIES AND MEMBERS’ EQUITY		$	73,853,097			$	74,675,194

 

		Three months  ended September 30, 2011				Three months  ended September 30, 2010				Nine months  ended September 30, 2011				Nine months ended September 30, 2010
		(unaudited)				(unaudited)				(unaudited)				(unaudited)
Revenue
Rooms department		$	2,167,782			$	1,932,975			$	8,846,380			$	8,300,101
Food and beverage department			440,876				419,511				1,887,038				1,567,029
Other operating departments			265,186				250,914				837,984				827,554
Total revenue			2,873,844				2,603,400				11,571,402				10,694,684
Expenses
Hotel operating expenses
Rooms department			527,917				515,659				1,865,238				1,772,533
Food and beverage department			375,832				348,170				1,405,916				1,220,033
Other operating departments			143,074				148,313				470,174				495,053
Indirect			1,456,369				1,469,658				4,517,778				4,746,496
Total hotel operating expenses			2,503,192				2,481,800				8,259,106				8,234,135
Depreciation and amortization			549,493				548,167				1,645,602				1,642,546
General and administrative			9,037				34,166				76,130				170,532
Total operating expenses			3,061,722				3,064,133				9,980,838				10,047,213
Net operating income (loss)			(187,878	)			(460,733	)			1,590,564				647,471
Interest expense			(443,740	)			(326,972	)			(1,337,084	)			(681,675	)
Interest income			—				1,078				—				4,883
Loss on expiration of land purchase option			(75,000	)			—				(75,000	)			—
Unrealized gain (loss) on hedging activities			(427,539	)			49,678				(822,814	)			49,678
Net income (loss)		$	(1,134,157	)		$	(736,949	)		$	(644,334	)		$	20,357

 

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12. Income Taxes

The components of the income tax provision (benefit) for the three months and nine months ended September 30, 2011 and 2010 are as follows (in thousands):

 

		Three months ended September 30, 2011				Three months ended September 30, 2010				Nine months ended September 30, 2011				Nine months ended September 30, 2010
		(unaudited)				(unaudited)				(unaudited)				(unaudited)
Current:
Federal		$	2			$	—			$	16			$	—
State			2				(2	)			57				38
			4				(2	)			73				38
Deferred:
Federal			(65	)			6				580				296
State			(11	)			(1	)			112				32
			(76	)			5				692				328
		$	(72	)		$	3			$	765			$	366

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 September 30, 2011				Three months  ended September 30, 2010				Nine months  ended September 30, 2011				Nine months  ended September 30, 2010
		(unaudited)				(unaudited)				(unaudited)				(unaudited)
Statutory federal income tax expense (benefit)		$	(533	)		$	(465	)		$	(785	)		$	(587	)
Effect of non-taxable REIT income			470				471				1,381				883
State income tax expense (benefit)			(9	)			(3	)			169				70
		$	(72	)		$	3			$	765			$	366

As of September 30, 2011 and December 31, 2010, the Company had a net deferred tax asset of approximately $4.1 million and $4.7 million, respectively, of which, approximately $4.1 million and $4.2 million, respectively, are due to accumulated net operating losses. These loss carryforwards will begin to expire in 2024 if not utilized by then. As of September 30, 2011 and December 31, 2010, 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 following table sets forth the reconciliation of the numerators and denominators in computing earnings per share for the three months and nine months ended September 30, 2011 and 2010.

 

		Three months  ended September 30, 2011				Three months  ended September 30, 2010				Nine months ended September 30, 2011				Nine months ended September 30, 2010
		(unaudited)				(unaudited)				(unaudited)				(unaudited)
Numerator
Net loss attributable to the Company for basic computation		$	(1,117,042	)		$	(1,004,350	)		$	(2,288,925	)		$	(1,528,625	)
Effect of the issuance of dilutive shares on the net loss attributable to the noncontrolling interest			(6,543	)			—				(9,935	)			—
Net loss attributable to the Company for dilutive computation		$	(1,123,585	)		$	(1,004,350	)		$	(2,298,860	)		$	(1,528,625	)
Denominator
Weighted average number of common shares outstanding for basic computation			9,701,786				9,541,286				9,627,006				9,415,593
Dilutive effect of stock awards			—				16,000				—				16,000
Dilutive effect of warrants			100,592				—				165,434				—

 

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		Three months  ended September 30, 2011				Three months  ended September 30, 2010				Nine months ended September 30, 2011				Nine months ended September 30, 2010
		(unaudited)				(unaudited)				(unaudited)				(unaudited)
Weighted average number common shares outstanding for dilutive computation			9,802,378				9,557,286				9,792,440				9,431,593
Basic net loss per share		$	(0.12	)		$	(0.11	)		$	(0.24	)		$	(0.16	)
Diluted net loss per share		$	(0.11	)		$	(0.11	)		$	(0.23	)		$	(0.16	)

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. But the effect of the allocation of net income (loss) attributable to the limited partners’ interests by the issuance of dilutive shares has been included.

Diluted net income (loss) per share takes into consideration the pro forma dilution of certain unvested stock awards during 2010 as well as the Warrant discussed in Note 7 issued in April 2011.

14. Subsequent Events

On October 3, 2011, the Company issued 50,000 shares of common stock in redemption of an equivalent number of units in the Operating Partnership.

On October 11, 2011, 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 September 15, 2011.

On October 17, 2011, The Company obtained a 5-year, $8.0 million mortgage with Premier Bank, Inc. on the Holiday Inn Brownstone 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 precedent 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 credit facility.

On October 17, 2011, the Company authorized payment of a quarterly dividend (distribution) of $0.02 per common share (and unit) to the stockholders (and unitholders of MHI Hospitality, L.P.) of record as of December 15, 2011. The dividend (distribution) is to be paid on January 11, 2012.

On November 1, 2011, the Company issued 15,000 shares of common stock in redemption of an equivalent number of units in the Operating Partnership and redeemed 2,600 additional units in the Operating Partnership for cash.

 

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 IPO and thereafter consummated the acquisition of the initial properties.

 

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Our hotel portfolio currently consists of ten full-service, upper-upscale and upscale hotels with 2,421 rooms, which operate under well-known brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. Nine of these hotels, totaling 2,110 rooms, are 100% owned by subsidiaries of our Operating Partnership. We also own a 25.0% indirect non-controlling interest in the Crowne Plaza Hollywood Beach Resort through a joint venture with Carlyle and we have leasehold interests in a resort condominium facility in Wrightsville Beach, North Carolina. As of September 30, 2011, we owned the following hotel properties:

 

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
Holiday Inn Brownstone			188			Raleigh, NC		December 21, 2004
Holiday Inn Laurel West			207			Laurel, MD		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
Sheraton Louisville Riverside			180			Jeffersonville, IN		September 20, 2006
			2,111
Joint Venture Property
Crowne Plaza Hollywood Beach Resort			311			Hollywood, FL		August 9, 2007
Total			2,422

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 75.9% 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 nine months ended September 30, 2011 and 2010, respectively, for the properties we wholly-owned during each respective reporting period.

 

		Three months ended September 30, 2011				Three months ended September 30, 2010				Nine months ended September 30, 2011				Nine months ended September 30, 2010
Occupancy %			68.6	%			69.2	%			68.2	%			68.1	%
ADR		$	106.23			$	102.19			$	109.97			$	104.03
RevPAR		$	72.88			$	70.76			$	75.02			$	70.80

Comparison of the Three Months Ended September 30, 2011 to the Three Months Ended September 30, 2010

Revenue. Total revenue for the three months ended September 30, 2011 increased approximately $0.5 million or 2.4% to approximately $20.0 million compared to total revenue of approximately $19.5 million for the three months ended September 30, 2010. Increases in revenue at our Tampa, Florida, and Jacksonville, Florida properties offset declines in revenue at our Hampton, Virginia property. Revenue for the period was adversely impacted by Hurricane Irene. The Company estimates the impact of Hurricane Irene on its portfolio was approximately $500,000 in lost revenue for three months ended September 30, 2011, including an approximately $1.90 negative effect on RevPAR for such period. The Company estimates that the overall effect of Hurricane Irene on its net income was approximately $350,000 for three months ended September 30, 2011.

Room revenue increased approximately $0.4 million or 3.0% to approximately $14.2 million for the three months ended September 30, 2011 compared to room revenue of approximately $13.8 million for the three months ended September 30, 2010. The

 

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increase in room revenue for the three months ended September 30, 2011 resulted from a 3.6% increase in ADR offset by a 0.6% decrease in occupancy as compared to the same period in 2010. Our properties in Tampa, Florida, Jacksonville, Florida and Philadelphia, Pennsylvania experienced the largest increases in room revenue.

Food and beverage revenues totaled approximately $4.7 million for the three months ended September 30, 2011, approximately the same level of food and beverage revenues for the three months ended September 30, 2010. Increases in banqueting revenue at our properties in Tampa, Florida, 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 increased approximately $0.1 million or 5.3% to approximately $1.2 million for the three months ended September 30, 2011 compared to revenue from other operating departments of approximately $1.1 million for the three months ended September 30, 2010.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses and management fees, were approximately $15.7 million, an increase of approximately $0.5 million or 3.2% for the three months ended September 30, 2011 compared to total hotel operating expenses of approximately $15.2 million for the three months ended September 30, 2010. The increase in hotel operating expense was mostly attributable to an increase in operating revenue.

Rooms expense for the three months ended September 30, 2011 increased approximately $0.1 million or 2.7% to approximately $4.1 million compared to rooms expense of approximately $4.0 million for the three months ended September 30, 2010. The increase was largely attributable to higher room revenue.

Food and beverage expenses for the three months ended September 30, 2011 increased approximately $0.1 million to approximately $3.3 million or 1.2% compared to food and beverage expenses of approximately $3.2 million for the three months ended September 30, 2010.

Indirect expenses at our wholly-owned properties for the three months ended September 30, 2011 increased approximately $0.4 million or 4.9% to approximately $8.2 million compared to indirect expenses of approximately $7.8 million for the three months ended September 30, 2010. Management fees and franchise fees increased significantly due to the increase in revenue. Sales and marketing costs, repairs and maintenance, energy and utility costs, 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 September 30, 2011 increased approximately $0.1 million or 3.0% to approximately $2.2 million compared to depreciation and amortization expense of approximately $2.1 million for the three months ended September 30, 2010.

Corporate General and Administrative. Corporate general and administrative expenses for the three months ended September 30, 2011 increased approximately $0.6 million or 85.8% to approximately $1.3 million compared to corporate general and administrative expense of approximately $0.7 million for the three months ended September 30, 2010 due primarily to costs associated with our aborted stock offering.

Interest Expense. Interest expense for the three months ended September 30, 2011 increased approximately $0.1 million or 5.3% to approximately $2.7 million compared to interest expense of approximately $2.6 million for the three months ended September 30, 2010. The increase was the combined result of a higher effective interest rate due mostly to the April 2011 issuance of mandatorily redeemable preferred stock, refinance of the mortgage on the Laurel, Maryland property and borrowings on the Bridge Financing.

Equity Income in Joint Venture. Equity income in joint venture for the three months ended September 30, 2011 represents our 25.0% share of the net loss of the Crowne Plaza Hollywood Beach Resort. For the three months ended September 30, 2011, our 25.0% share of the net loss of the joint venture increased approximately $0.1 million to approximately $0.3 million compared to a net loss of approximately $0.2 million for the three months ended September 30, 2010. All of the increased net loss of the joint venture was attributable to an unrealized loss on hedging activities. For the three months ended September 30, 2011, the hotel reported occupancy of 69.4%, ADR of $109.20 and RevPAR of $75.76. This compares with results reported by the hotel for the three months ended September 30, 2010 of occupancy of 71.8%, ADR of $94.13 and RevPAR of $67.56.

Income Taxes. The income tax provision is primarily derived from the operations of our TRS Lessee. We realized an income tax benefit of approximately $0.1 million for the three months ended September 30, 2011 compared to almost no income tax benefit or expense for the three months ended September 30, 2010. Our TRS lessee experienced taxable losses during the three months ended September 30, 2011 compared to almost no taxable income or loss during the three months ended September 30, 2010.

Net Loss. The net loss for the three months ended September 30, 2011 increased approximately $0.1 million or 9.0% to approximately $1.5 million compared to a net loss of approximately $1.4 million for the three months ended September 30, 2010 as a result of the operating results discussed above.

 

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Comparison of the Nine Months Ended September 30, 2011 to the Nine Months Ended September 30, 2010

Revenue. Total revenue for the nine months ended September 30, 2011 increased approximately $3.1 million or 5.3% to approximately $61.7 million compared to total revenue of approximately $58.6 million for the nine months ended September 30, 2010. Increases in revenue at our Tampa, Florida, Wilmington, North Carolina, Jeffersonville, Indiana and Philadelphia, Pennsylvania properties offset declines in revenue at our Laurel, Maryland property. Revenue growth for the period was adversely impacted by Hurricane Irene.

Room revenue increased approximately $2.4 million or 6.0% to approximately $43.2 million for the nine months ended September 30, 2011 compared to room revenue of approximately $40.8 million for the nine months ended September 30, 2010. The increase in room revenue for the nine months ended September 30, 2011 resulted from a 5.6% increase in ADR and a 0.3% increase in occupancy as compared to the same period in 2010. Room revenue increased at all our properties with the exception of our property in Laurel, Maryland.

Food and beverage revenues increased approximately $0.6 million or 4.1% to approximately $15.0 million for the nine months ended September 30, 2011 compared to food and beverage revenues of approximately $14.4 million for the nine months ended September 30, 2010. Increases in banqueting revenue at our properties in Tampa, Florida and Wilmington, North Carolina offset decreases in food and beverage revenue at our properties in Hampton, Virginia and Savannah, Georgia.

Revenue from other operating departments increased approximately $0.1 million or 2.4% to approximately $3.5 million for the nine months ended September 30, 2011 compared to revenue from other operating departments of approximately $3.4 million for the nine months ended September 30, 2010.

Hotel Operating Expenses. Hotel operating expenses, which consist of room expenses, food and beverage expenses, other direct expenses and management fees, were approximately $46.5 million, an increase of approximately $2.1 million or 4.8% for the nine months ended September 30, 2011 compared to total hotel operating expenses of approximately $44.4 million for the nine months ended September 30, 2010. The increase in hotel operating expense was mostly attributable to an increase in operating revenue.

Rooms expense for the nine months ended September 30, 2011 increased approximately $0.5 million or 4.8% to approximately $12.0 million compared to rooms expense of approximately $11.5 million for the nine months ended September 30, 2010. The increase was largely attributable to higher room revenue, but was also affected by higher payroll costs related to fewer vacant positions and higher unemployment taxes in the current period and employee furloughs in the prior period.

Food and beverage expenses for the nine months ended September 30, 2011 increased approximately $0.3 million to approximately $10.1 million or 3.5% compared to food and beverage expenses of approximately $9.8 million for the nine months ended September 30, 2010. 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 32.2% to 32.6% offset the cost of higher volume.

Indirect expenses at our wholly-owned properties for the nine months ended September 30, 2011 increased approximately $1.3 million or 5.9% to approximately $23.9 million compared to indirect expenses of approximately $22.6 million for the nine months ended September 30, 2010. Management fees and franchise fees increased significantly due to the increase in revenue. Energy costs increased as well due to the increase in occupancy and higher costs due to the expiration of favorable fixed rate contracts. Sales and marketing costs, 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 increased approximately $0.1 million or 1.2% to approximately $6.5 million for the nine months ended September 30, 2011 compared to depreciation and amortization expense of approximately $6.4 million for the nine months ended September 30, 2010.

Corporate General and Administrative. Corporate general and administrative expenses for the nine months ended September 30, 2011 increased approximately $0.5 million or 17.4% to approximately $3.2 million compared to corporate general and administrative expense of approximately $2.7 million for the nine months ended September 30, 2010 due primarily to costs associated with our aborted stock offering.

Interest Expense. Interest expense for the nine months ended September 30, 2011 increased approximately $0.7 million or 9.0% to approximately $8.1 million compared to interest expense of approximately $7.4 million for the nine months ended September 30, 2010. The increase was the combined result of a lower effective interest rate on our line of credit in the period prior to the June 2010 amendment to the credit agreement as well as higher interest costs in the current period associated with the April 2011 issuance of mandatorily redeemable preferred stock.

Equity Income in Joint Venture. Equity income in joint venture for the nine months ended September 30, 2011 represents our 25.0% share of the net loss of the Crowne Plaza Hollywood Beach Resort. For the nine months ended September 30, 2011, our 25.0% share of the net loss of the joint venture was approximately $0.2 million compared to almost no net loss or income from the joint venture for the nine months ended September 30, 2010. All of the net loss of the joint venture was attributable to an unrealized loss

 

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on hedging activities. For the nine months ended September 30, 2011, the hotel reported occupancy of 79.9%, ADR of $130.47 and RevPAR of $104.19. This compares with results reported by the hotel for the nine months ended September 30, 2010 of occupancy of 79.7%, ADR of $122.59 and RevPAR of $97.76.

Income Taxes. The income tax provision is primarily derived from the operations of our TRS Lessee. We realized income tax expense of approximately $0.8 million for the nine months ended September 30, 2011, an increase of approximately $0.4 million, compared to income tax expense of approximately $0.4 million for the nine months ended September 30, 2010. The income of our TRS lessee subject to tax for the nine months ended September 30, 2011 was significantly larger than the income subject to tax for the nine months ended September 30, 2010.

Net Loss. The net loss for the nine months ended September 30, 2011 increased approximately $1.0 million or 46.9% to approximately $3.1 million as compared to a net loss of approximately $2.1 million for the nine months ended September 30, 2010 as a result of the operating results discussed above.

Funds From Operations

Funds from Operations (“FFO”) is used by industry analysts and investors as a supplemental operating performance measure of an equity REIT. FFO is calculated in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts, NAREIT. FFO, as defined by NAREIT, represents net income or loss determined in accordance with GAAP, excluding extraordinary items as defined under GAAP and gains or losses from sales of previously depreciated operating real estate assets, plus certain non-cash items such as real estate asset depreciation and amortization, and after adjustment for any 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 nine months ended September 30, 2011 and 2010, respectively, (unaudited):

 

		Three months ended September 30, 2011				Three months ended September 30, 2010				Nine months ended September 30, 2011				Nine months ended September 30, 2010
Net loss attributable to the Company		$	(1,117,042	)		$	(1,004,350	)		$	(2,288,925	)		$	(1,528,625	)
Add noncontrolling interest			(377,859	)			(366,400	)			(785,948	)			(564,435	)
Add depreciation and amortization			2,187,541				2,123,761				6,460,928				6,381,378
Add equity in depreciation of joint venture			156,123				136,695				430,150				409,660
Add loss (Subtract gain) on disposal of assets			9,894				84,128				(2,361	)			84,128
FFO		$	858,657			$	973,834			$	3,813,844			$	4,782,106
Weighted average shares outstanding			9,701,786				9,541,286				9,627,006				9,415,593
Weighted average units outstanding			3,239,439				3,366,656				3,305,574				3,476,389
Weighted average shares and units			12,941,225				12,907,942				12,932,580				12,891,982
FFO per share and unit		$	0.07			$	0.08			$	0.29			$	0.37

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 nine months ended September 30, 2011 was approximately $7.4 million. We expect that the net cash provided by operations will be

 

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adequate to fund our continuing operations, monthly and quarterly scheduled payments of principal and interest (excluding any balloon payments due upon maturity of a debt) and the payment of dividends in accordance with federal income tax laws which require us to make annual distributions to our stockholders of at least 90% of our REIT taxable income, excluding net capital gains.

Investing Activities. Approximately $4.2 million was spent during the nine months ended September 30, 2011 on capital improvements and the replacement of furniture, fixtures and equipment.

Financing Activities. In April 2011, we issued 25,000 shares of the Preferred Stock and a Warrant to purchase shares of common stock for gross proceeds of $25.0 million, of which we used approximately $22.7 million to reduce our indebtedness on the line of credit. In August 2011, we obtained an 18-month extension on the mortgage on the Crowne Plaza Jacksonville repaying $4.0 million in principal which we obtained by accessing an equivalent amount of Bridge Financing. Also in August 2011, we obtained a $7.5 million mortgage on the Holiday Inn Laurel and used the proceeds to repay a portion of the balance on the line of credit.

During the nine months ended September 30, 2011, we paid approximately $0.8 million of scheduled principal payments toward the mortgages on the Hilton Wilmington Riverside, the Hilton Savannah DeSoto, the Holiday Inn Laurel and the Crowne Plaza Hampton Marina.

During the nine months ended September 30, 2011, we also paid approximately $1.5 million in deferred financing costs in relation to the sixth amendment to the credit agreement, issuance of the Preferred Stock and the refinance or extension of the mortgages on several of our properties and provided $0.75 million in cash collateral in conjunction with the extension of the mortgage on the Crowne Plaza Hampton Marina.

Capital Expenditures

Since mid-2004, we have completed product improvement plans (“PIPs”) in connection with the licensing or re-licensing at eight of our nine wholly-owned properties. With the exception of a PIP in connection with the re-licensing of the Holiday Inn Brownstone as the Doubletree by Hilton Brownstone-University before its current franchise license expires in December 2011, we anticipate that capital expenditures for the replacement and refurbishment of furniture, fixtures and equipment over the next 12 to 24 months will be 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 light of the recent slowdown of the economy and current economic climate as well as 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 PIP should total 2.75% to 3.25% of gross revenues during the next 12 to 24 months.

We estimate the remaining capital expenditures related to the PIP underway in Raleigh, North Carolina will be approximately $0.7 million and expect to fund it out of operations. We expect that most of the capital expenditures for the replacement or refurbishment of furniture, fixtures and equipment at our remaining properties will be funded by our replacement reserve accounts, other than costs that we incur to make capital improvements that may be required by our franchisors. We maintain escrow accounts with most of our lenders which are reserved for capital improvements or expenditures. On a monthly basis, we deposit an amount equal to 4.0% of gross revenue for the Hilton Savannah DeSoto, the Hilton Wilmington Riverside and the Crowne Plaza Hampton Marina and 4.0% of room revenues for the Crowne Plaza Jacksonville Riverfront. Commencing in June 2010, we began depositing an amount equal to 3.0% of room revenues for our remaining wholly-owned properties.

Liquidity and Capital Resources

As of September 30, 2011, we had cash and cash equivalents of approximately $9.0 million, of which approximately $3.6 million was in restricted reserve accounts and real estate tax and insurance escrows. As of September 30, 2011, our credit facility had an outstanding balance of approximately $45.1 million. 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 April 2011, we sold 25,000 shares of redeemable Preferred Stock and generated gross proceeds of approximately $25.0 million. In conjunction with the sale of redeemable Preferred Stock, we executed an amendment to our credit agreement and used approximately $22.7 million of the proceeds to reduce the outstanding balance on the credit facility. Among other modifications to the existing amended credit agreement, the amendment extends the maturity date for three years to May 2014, reduces the additional interest from 4.00% to 3.50% and removes the LIBOR floor of 0.75%, and modifies certain covenants. We estimate that the reduced interest expense related to the reduced additional interest on the remaining balance on the credit facility is approximately the same as the increased cost related to the redeemable Preferred Stock.

 

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Coincident with the sale of redeemable Preferred Stock and execution of the sixth amendment to the credit agreement, we executed an agreement with Essex Equity High Income Joint Investment Vehicle, LLC allowing us to borrow up to $10.0 million (“Bridge Financing”) at a fixed rate of 9.25%. As of September 30, 2011, we have $6.0 million of borrowing capacity.

In June 2011, we entered into an agreement with TowneBank to extend the maturity of the mortgage on the Crowne Plaza Hampton Marina until September 30, 2012. Under the terms of the extension, we 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%. We also pledged $750,000 in cash collateral held by the lender in an interest-bearing account, which will be used to reduce the outstanding balance of the mortgage in December 2011 if the property does not meet certain profitability thresholds.

In August 2011, we entered into an agreement to extend the maturity of the mortgage on the Crowne Plaza Jacksonville Riverfront to January 2013. In conjunction with the extension, we drew upon the Bridge Financing to reduce the outstanding indebtedness on the property by $4.0 million, thus reducing the mortgage loan’s current outstanding principal amount to $14.0 million.

On August 5, 2011, we obtained a 10-year, $7.5 million mortgage with Bank of Georgetown on the Holiday Inn Laurel West hotel property. The mortgage will bear 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%. Proceeds of the mortgage were used to pay down a related portion of our indebtedness under the credit facility.

On October 17, 2011, we obtained a 5-year, $8.0 million mortgage with Premier Bank, Inc. on the Holiday Inn Brownstone 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, if certain conditions have been met, 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 our indebtedness under the credit facility.

We believe the recovering economy will provide opportunities to acquire properties at attractive prices. However, with the constraints of the covenants in our credit agreement and other financing agreements, 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 joint venture transactions and additional 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.

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, amounts outstanding under our secured credit facility, redemption of the Preferred Stock, repayment of draws under the Bridge Financing 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 of the Company and/or their subsidiary entities of secured and unsecured debt securities to the extent permitted by our credit 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

Our ability to make distributions is constrained by the terms of our credit agreement, as amended, the Preferred Stock instrument and the Note Agreement. The credit agreement, as amended, 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 credit agreement also provides that we may make additional dividend distributions so long as no event of default exists at the time, or after giving effect to such additional distributions, if we maintain both a minimum liquidity position of

 

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$7.5 million and satisfy a debt yield ratio of EBITDA to total liabilities of at least 10.0% before and after giving effect to such distribution, provided the aggregate amount of total distributions cannot exceed 90.0% of FFO (including distributions on Preferred Stock in the calculation of FFO) for the previous twelve months, all as defined in the credit agreement, as amended. Pursuant to the sixth amendment to the credit agreement, total liabilities and FFO are defined such that it eases our compliance with the credit agreement’s restrictions on additional distributions. The Preferred Stock instrument similarly 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 credit agreement, the Preferred Stock instrument and the Note Agreement.

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 2009, we amended our dividend policy and reduced the level of our cash dividend payments. In July 2011, in part due to improving operating trends, we reevaluated our quarterly dividend policy and reinstated our quarterly dividend (distribution). On July 18, 2011, we authorized 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. The dividend (distribution) was paid on October 11, 2011. On October 17, 2011, we authorized payment of another 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 December 15, 2011. The dividend (distribution) is to be paid on January 11, 2012.

The amount of future distributions will be based upon quarterly operating results, general economic conditions, requirements for capital improvements, the availability of debt and equity capital, the Internal Revenue Code’s annual distribution requirements, the terms of our credit agreement, as amended, or any future or similar credit agreement, the Preferred Stock instrument and the 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 board of 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. With respect to dividends on Preferred Stock, the credit agreement, as amended, provides that they may only be paid from unrestricted cash, if all interest then owing under the credit agreement has been paid, and if no event of default, or breach of certain financial covenants, exists on the payment date both before and after giving effect to the payment of preferred dividends.

Off-Balance Sheet Arrangements

Through a joint venture with a Carlyle subsidiary, we own a 25.0% indirect, non-controlling 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, non-controlling interest.

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 non-controlling 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 non-controlling 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.

 

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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 7-39 years for buildings and improvements and 3-10 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.

There were no charges for impairment recorded for the nine months ended September 30, 2011 or 2010.

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 revenue, including room, food, beverage and other hotel revenue, is 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.

 

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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 September 30, 2011. 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 the Recent Accounting Pronouncements section 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 the recent economic downturn, that affect occupancy rates at our 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 we operate;

 

•

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 our indebtedness and our ability to meet covenants in our debt agreements;

 

•

management and performance of our hotels;

 

•

risks associated with the conflicts of interest of our officers and directors;

 

•

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

 

•

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

 

•

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

 

•

our ability to successfully expand into new markets;

 

•

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

 

•

our ability to maintain our qualification as a REIT; and

 

•

our 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.

 

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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 credit agreement. 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 September 30, 2011, we had approximately $95.3 million of fixed-rate debt and approximately $58.5 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 8.02%. 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 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 credit facility remain at approximately $58.5 million, the balance at September 30, 2011, the impact on our annual interest incurred and cash flows of a one percent increase in 30-day LIBOR would be approximately $573,000.

As of December 31, 2010, we had approximately $63.2 million of fixed-rate debt and approximately $88.7 million of variable-rate debt. The weighted-average interest rate on the fixed-rate debt was 6.67%. 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 2.0% – as well as the loan from the Carlyle Affiliate Lender and the gap between the balance on the credit facility and the $30.0 million notional amount of the interest-rate swap purchased on June 10, 2010. 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 credit facility remain at approximately $88.7 million, the balance at December 31, 2010, the impact on our annual interest incurred and cash flows of a one percent change in 30-day LIBOR would be approximately $587,000.

 

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 September 30, 2011, 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, 2010 and our subsequent periodic reports.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

 

Item 3.

Defaults Upon Senior Securities

Not applicable.

 

Item 4.

[Removed and Reserved]

 

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)
10.4		Strategic Alliance Agreement among MHI Hospitality Corporation, MHI Hospitality, L.P. and MHI Hotels Services, LLC.
10.5		Master Management Agreement by and between MHI Hospitality TRS, LLC and MHI Hotels Services, LLC.
10.11		Agreement to Assign and Sublease Common Space Lease by and between MHI Hospitality L.P. and MHI Hotels, LLC.
10.12		Agreement to Assign and Sublease Commercial Space Lease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc.
10.13		Lease Agreement by and between Philadelphia Hotel Associates LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease Agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K).
10.15		Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc.
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.

 

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Exhibit Number		Description of Exhibit
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.

 

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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: November 9, 2011				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)
10.4		Strategic Alliance Agreement among MHI Hospitality Corporation, MHI Hospitality, L.P. and MHI Hotels Services, LLC.
10.5		Master Management Agreement by and between MHI Hospitality TRS, LLC and MHI Hotels Services, LLC.
10.11		Agreement to Assign and Sublease Common Space Lease by and between MHI Hospitality L.P. and MHI Hotels, LLC.
10.12		Agreement to Assign and Sublease Commercial Space Lease by and between MHI Hospitality L.P. and MHI Hotels Two, Inc.
10.13		Lease Agreement by and between Philadelphia Hotel Associates LP and MHI Hospitality TRS, LLC (with a schedule of eight additional agreements that are substantially identical in all material respects to the Lease Agreement, except as identified in such schedule, and are not being filed herewith per Instruction 2 to Item 601 of Regulation S-K).
10.15		Contribution Agreement by and between MHI Hotels Services, LLC, MHI Hotels, LLC and MHI Hotels Two, Inc.
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.

 

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