Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             .

HIGHLAND HOSPITALITY CORPORATION

(Exact name of registrant as specified in its charter)

8405 Greensboro Drive, Suite 500, McLean, Virginia 22102

Telephone Number (703) 336-4901

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

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, and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

The aggregate market value of the Registrant’s common stock held by non-affiliates of the registrant was approximately $461,000,000, based on the closing price quoted by the New York Stock Exchange on March 9, 2004. As of March 9, 2004, there were 39,930,000 shares of the Registrant’s common stock issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Part III of this Form 10-K incorporates by reference certain portions of the Registrant’s proxy statement for its 2004 annual meeting of stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report.

Table of Contents

HIGHLAND HOSPITALITY CORPORATION

INDEX

2

Table of Contents

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Information included and incorporated by reference in this Form 10-K 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:

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.

3

Table of Contents

PART I

Item 1.    Business

Organization and Initial Public Offering

Highland Hospitality Corporation is a self-advised real estate investment trust (“REIT”) that was incorporated in Maryland in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside the United States. We commenced operations on December 19, 2003 when we completed our initial public offering (“IPO”) and concurrently consummated the acquisition of three hotel properties.

The IPO consisted of the sale of 30,000,000 shares of common stock at a price of $10 per share, resulting in gross proceeds of $300 million and net proceeds (after deducting underwriting discounts and offering expenses) of approximately $277 million. Concurrent with the IPO, we sold in private placement transactions an aggregate of 4,550,000 shares of common stock at a price per share equal to the IPO price, less an amount equal to the underwriting discount of $0.70 per share. The proceeds generated from the private placement transactions were approximately $42.3 million. On December 26, 2003, we sold an additional 4,500,000 shares of common stock at a price of $9.30 per share, net of the underwriting discount, as a result of the exercise of the underwriters’ over-allotment option, resulting in additional net proceeds of approximately $41.9 million. The total net proceeds generated from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option were approximately $361.2 million.

Substantially all of our assets are held by, and all of our operations are conducted through, Highland Hospitality, L.P., our operating partnership (the “Operating Partnership”). In order for us to qualify as a REIT, neither our company nor the Operating Partnership can operate hotels directly. Therefore, the Operating Partnership, which is owned 97.7% by us and 2.3% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly-owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels under management contracts.  HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

As of March 9, 2004, we owned seven hotel properties with 1,725 rooms.

Our corporate office is located at 8405 Greensboro Drive, Suite 500, McLean, Virginia 22102. Our telephone number is (703) 336-4901.

Acquisition of Hotel Properties

On December 19, 2003, concurrent with the completion of the IPO, we acquired 100% of the equity interests in Portsmouth Hotel Associates, LLC, A/H-BCC Virginia Beach Hotel, LLC, and Sugar Land Hotel Associates, L.P. Barceló Crestline Corporation (“Barceló Crestline”), which was the sponsor of our formation and IPO, owned equity interests in the three entities.

Portsmouth Hotel Associates, LLC, which is considered our predecessor for accounting purposes, leases the 250-room Portsmouth Renaissance hotel and adjoining conference center located in Portsmouth, Virginia from the Industrial Development Authority of the City of Portsmouth, pursuant to two separate lease agreements, each for an initial term of 50 years ending May 2049. Portsmouth Hotel Associates, LLC was acquired for approximately $13 million, which included the repayment of a mortgage loan which encumbered the hotel property of approximately $11.9 million and the issuance of 529,635 Operating Partnership units valued at approximately $1.1 million.

4

Table of Contents

A/H-BCC Virginia Beach Hotel, LLC owns the 176-room Hilton Garden Inn Virginia Beach Town Center hotel located in Virginia Beach, Virginia. A/H-BCC Virginia Beach Hotel, LLC was acquired for approximately $20 million, which included the repayment of a construction loan which encumbered the hotel property of approximately $17.5 million and the issuance of 285,376 Operating Partnership units valued at approximately $2.5 million. In addition, we have agreed to pay the third-party member additional purchase consideration in the form of Operating Partnership units if the Hilton Garden Inn Virginia Beach Town Center hotel exceeds certain agreed-upon operating results during the second 12-month period or third 12-month period following the opening date of the hotel.

Sugar Land Hotel Associates, L.P. owns the 300-room Sugar Land Marriott hotel and leases the adjoining conference center and parking facility located in Sugar Land, Texas from the Sugar Land Development Authority, pursuant to a lease agreement for a term of 99 years ending October 2102. Sugar Land Hotel Associates, L.P. was acquired for approximately $32.6 million, which included the repayment of a construction loan which encumbered the hotel property and a mezzanine loan in an aggregate amount of approximately $29.7 million, and the issuance of 138,708 Operating Partnership units valued at approximately $0.2 million. In addition, we have agreed to pay Barceló Crestline up to $1.8 million in the form of Operating Partnership units as additional purchase consideration if the Sugar Land Marriott hotel exceeds certain agreed-upon operating results over the 36-month period following our acquisition of the hotel.

On December 29, 2003, we acquired the 252-room Plaza San Antonio Marriott hotel located in San Antonio, Texas for approximately $32.7 million in cash. On December 30, 2003, we acquired the 351-room Hyatt Regency Savannah hotel located in Savannah, Georgia for approximately $49.2 million in cash.

Subsequent to year end, we acquired two additional hotel properties. On January 8, 2004, we acquired the 238-room Hilton Tampa Westshore hotel located in Tampa, Florida for approximately $30.2 million, which included the assumption of mortgage debt which encumbers the hotel property of approximately $17 million. On January 12, 2004, we acquired the 158-room Hilton Garden Inn Baltimore/Washington International (BWI) Airport hotel located in Linthicum, Maryland for approximately $22.7 million in cash.

All seven hotel acquisitions were funded with proceeds from the IPO. See Item 2 of this Form 10-K for additional detail on the hotel properties.

Business Strategy

We intend to evaluate our portfolio on a regular basis to determine if our hotel properties continue to satisfy our current investment criteria. We believe that the following investment criteria and strategies will promote our continued growth and our total return to stockholders:

External Growth—We will seek to focus our investments in upscale full-service, premium limited-service and extended stay hotels located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in beachfront destinations outside the United States. We believe that these types of hotels currently offer the opportunity for better risk-adjusted returns than hotels in other sectors in the industry. Within our target sectors, we will seek to acquire hotel properties that have superior locations within their respective markets, are in markets with high barriers to entry, are market leaders or are new, or relatively new properties and well-maintained. We will also consider investments in hotel properties that possess sound operating fundamentals but are underperforming in their respective markets and would benefit from renovation, re-branding or a change in management.

In the United States, we will seek to invest in hotels operating under national franchise brands such as Marriott, Hilton, Hyatt Hotels, Renaissance, Westin, Sheraton, Residence Inn by Marriott, Embassy Suites, Homewood Suites, Courtyard by Marriott and Hilton Garden Inn. However, our ability to operate a hotel under these brands is subject to the franchisor’s approval of any application we would submit to operate a particular

5

Table of Contents

facility under such brand and our execution of a franchise license agreement with the franchisor. Outside the United States, we will focus on acquiring all-inclusive resorts operating under the Barceló brand name, or other resorts that can be rebranded with the Barceló name, that meet our investment criteria. “Barceló” means Barceló Corporación Empresarial, S.A., which is based in Palma de Mallorca, Spain and is one of the world’s largest and most respected hospitality companies with 230 hotels owned, managed, leased or franchised in 19 countries on four continents. Barceló Crestline is a wholly-owned subsidiary of Barceló.

Stabilized Assets—We believe that over the next several years existing upscale full-service, premium limited-service and extended stay hotels located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in beachfront destinations outside the United States will offer the opportunity for better risk-adjusted returns than hotels in other sectors in the industry. Within our target sectors, we will seek to acquire hotel properties that meet the following criteria:

Because we believe hotel properties that possess these characteristics currently can be acquired at prices below replacement costs, we expect these hotel properties to provide stable returns over the long term.

Renovation, Repositioning and Re-branding Opportunities—We believe hotel properties that possess sound operating fundamentals but are underperforming in their respective markets would benefit from renovation, repositioning or re-branding efforts. We intend to pursue opportunities for:

Internal Growth—We will work with our hotel management companies to aggressively pursue ways to enhance the profitability of our hotels. We will seek to negotiate management agreements that will align our managers’ interests with ours, which is to generate revenue growth while producing acceptable operating profits. We will work with our managers to identify cost-savings opportunities and projects that result in a positive return on investment.

6

Table of Contents

Strategic Alliance Agreement

On December 19, 2003, we entered into a seven-year strategic alliance agreement with Barceló Crestline pursuant to which (i) Barceló Crestline agrees to refer to us (on an exclusive basis) hotel acquisition opportunities in the United States presented to Barceló Crestline or its subsidiaries, other than opportunities that primarily relate to third-party management arrangements offered to Barceló Crestline, and (ii) unless a majority of our independent directors in good faith concludes for valid business reasons that another management company should manage a hotel owned by us, we agree to offer Barceló Crestline or its subsidiaries the right to manage hotel properties that we acquire in the United States, unless the hotel is encumbered by a management agreement that would extend beyond the date of our acquisition of the hotel and a termination fee is payable to terminate the existing management agreement (unless Barceló Crestline pays such termination fee).

Lease Agreements

In order for us to qualify as a REIT, neither our company nor the Operating Partnership or its subsidiaries can operate our hotels directly. Our Operating Partnership, or subsidiaries of our Operating Partnership, as lessors, will lease our hotels to HHC TRS, or subsidiaries of HHC TRS, as TRS lessees, and the TRS lessees will enter into management agreements with Barceló Crestline or its subsidiaries, or other operators, to manage the hotels. Each lease for the hotels will have a non-cancelable term of ten years, subject to earlier termination upon the occurrence of certain contingencies described in the lease.

During the term of each lease, the TRS lessees will be obligated to pay (i) the greater of a fixed annual base rent or percentage rent and (ii) certain other additional charges. Base rent will accrue and be paid monthly. Percentage rent is calculated by multiplying fixed percentages by gross room revenues, food and beverage revenues, and other revenues for each of the hotels and will be paid quarterly.

Management Agreements

Six of our seven hotels operate under management agreements with Crestline Hotels & Resorts, Inc., which is a wholly-owned subsidiary of Barceló Crestline, each for a 10-year term. We expect to engage Crestline Hotels & Resorts to manage additional United States hotels that we acquire in the future under management agreements on substantially the same terms as existing agreements. Crestline Hotels & Resorts receives a base management fee, and if the hotels meet and exceed certain thresholds, an additional incentive management fee. The base management fee for the hotels is generally between 2% and 3.5% of total gross revenues from the hotels. The incentive management fee, if any, for each hotel will be due annually in arrears within 105 days after the end of each fiscal year and will be equal to 15% of the amount by which operating profit for the fiscal year exceeds 11% of our capitalized investment in the hotel. Crestline Hotels & Resorts will not be entitled to receive any incentive fee in any fiscal year in which the operating profit of the TRS lessee has not equaled at least 11% of our investment in the hotel. The management agreements place a cap on the total amount of combined base and incentive management fees paid to Crestline Hotels & Resorts at 4.5% of gross revenues for each fiscal year.

The management agreements provide for early termination by either us or Crestline Hotels & Resorts if certain events or conditions occur, including but not limited to, the hotel not achieving certain agreed-upon operating results, Crestline Hotel & Resorts no longer being an “eligible independent contractor”, and upon foreclosure or sale of the hotel. In certain cases of early termination of the management agreement with respect to one or more of the hotels, the TRS lessee must pay Crestline Hotels & Resorts termination fees, plus any amounts otherwise due to Crestline Hotels & Resorts pursuant to the terms of the management agreement.

The Hyatt Regency Savannah hotel operates under a management agreement with Hyatt Corporation that expires on December 31, 2011. Under the agreement, Hyatt Corporation may extend the term of the agreement for two successive periods of ten years each, provided that Hyatt Corporation provides us notice of its renewal election at least 18 months prior to expiration of the applicable term. Hyatt Corporation receives a base

7

Table of Contents

management fee, payable on a monthly basis, equal to 4% of the monthly gross receipts. Hyatt Corporation is also eligible to receive an incentive fee, payable in monthly installments, equal to the amount by which 20% of the profit for a fiscal year exceeds the base fee for that fiscal year. The management agreement may not be terminated earlier than the stated term except with respect to certain events of casualty.

Franchise Agreements

Six of our seven hotels operate under franchise licenses from national hotel companies. Our management agreement with Hyatt Corporation allows the Hyatt Regency Savannah hotel to operate under the Hyatt brand. We anticipate that most of the additional hotel properties we acquire will operate under franchise licenses. We believe that the public’s perception of quality associated with a franchisor is an important feature in the operation of a hotel. Franchisors provide a variety of benefits for franchisees, which include national advertising, publicity and other marketing programs designed to increase brand awareness, training of personnel, continuous review of quality standards, and centralized reservation systems.

The franchise agreements are entered into by our TRS lessees. The hotel franchise licenses generally specify certain management, operational, record keeping, accounting, reporting and marketing standards and procedures with which the TRS lessee must comply. The franchise licenses obligate the TRS lessee to comply with the franchisors’ standards and requirements with respect to training of operational personnel, safety, maintaining specified insurance, the types of services and products ancillary to guest room services that may be provided, display of signs, and the type, quality and age of furniture, fixtures and equipment included in guest rooms, lobbies and other common areas.

As of December 31, 2003, of the six hotels’ franchise licenses, one expires in 2019, one expires in 2022, one expires in 2023, and three expire in 2024. The franchise agreements provide for termination at the franchisor’s option upon the occurrence of certain events, including the TRS lessees’ failure to pay royalties and fees or perform its other covenants under the franchise agreement, bankruptcy, abandonment of the franchise, commission of a felony, assignment of the franchise without the consent of the franchisor, or failure to comply with applicable law in the operation of the relevant hotel. The franchise agreements will not renew automatically upon expiration. The TRS lessees are responsible for making all payments under the franchise agreements to the franchisors. Under the franchise agreements, the TRS lessees pay a franchise fee generally between 4% and 5% of room revenues, plus additional fees that amount to between 3% and 4% of room revenues from the hotels.

Tax Status

We have elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. To qualify as a REIT, we must meet a number of organizational and operational requirements, including a requirement that we currently distribute at least 90% of our taxable income (excluding net capital gains) to our stockholders. It is our current intention to adhere to these requirements and maintain our qualification for taxation as a REIT. As a REIT, we generally will not be subject to federal corporate income tax on that portion of our net income that is currently distributed to stockholders. If we fail to qualify for taxation as a REIT in any taxable year, we will be subject to federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and may not be able to qualify as a REIT for four subsequent taxable years. Even if we qualify for taxation as a REIT, we may be subject to certain state and local taxes on our income and property, and to federal income and excise taxes on our undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes.

Seasonality

Demand in the lodging industry is affected by recurring seasonal patterns. For non-resort properties, demand is generally lower in the winter months due to decreased travel and higher in the spring and summer months during the peak travel season. We expect that our operations will generally reflect non-resort seasonality patterns.

8

Table of Contents

Accordingly, we expect that we will have lower revenue, operating income and cash flow in the first and fourth quarters and higher revenue, operating income and cash flow in the second and third quarters. These general trends are, however, expected to be greatly influenced by overall economic cycles.

Competition

The hotel industry is highly competitive with various participants competing on the basis of price, level of service and geographic location. Each of our hotels is located in a developed area that includes other hotel properties. The number of competitive hotel properties in a particular area could have a material adverse effect on occupancy, average daily rate (“ADR”) and revenue per available room (“RevPAR”) of our hotels or at hotel properties acquired in the future. We believe that brand recognition, location, the quality of the hotel, consistency of services provided, and price are the principal competitive factors affecting our hotels.

Environmental Matters

In connection with the ownership and operation of the hotels, we are subject to various federal, state and local laws, ordinances and regulations relating to environmental protection. Under these laws, a current or previous owner or operator of real estate may be liable for the costs of removal or remediation of certain hazardous or toxic substances on, under, or in such property. Such laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the presence of hazardous or toxic substances. In addition, the presence of contamination from hazardous or toxic substances, or the failure to remediate such contaminated property properly, may adversely affect the owner’s ability to borrow using such property as collateral. Furthermore, a person who arranges for the disposal or treatment of a hazardous or toxic substance at a property owned by another, or who transports such substance to or from such property, may be liable for the costs of removal or remediation of such substance released into the environment at the disposal or treatment facility. The costs of remediation or removal of such substances may be substantial, and the presence of such substances may adversely affect the owner’s ability to sell such real estate or to borrow using such real estate as collateral. In connection with the ownership and operation of the hotels, we may be potentially liable for such costs.

We believe that our hotels are in compliance, in all material respects, with all federal, state and local environmental ordinances and regulations regarding hazardous or toxic substances and other environmental matters, the violation of which would have a material adverse effect on us. We have not received written notice from any governmental authority of any material noncompliance, liability or claim relating to hazardous or toxic substances or other environmental matters in connection with any of our present hotel properties.

Employees

As of March 9, 2004, we employed 10 persons, all of whom work at our corporate office in McLean, Virginia. All persons employed in the day-to-day operations of the hotels are employees of the management companies engaged by the TRS lessees to operate such hotels.

Executive Officers

The following table lists our executive officers as of December 31, 2003:

9

Table of Contents

James L. Francis is our President and Chief Executive Officer, a position he has held since our formation. Mr. Francis served as the Chief Operating Officer, Chief Financial Officer and Treasurer of Barceló Crestline Corporation from June 2002 to December 2003, and served as Executive Vice President and Chief Financial Officer of Crestline Capital Corporation, prior to its acquisition by Barceló, from December 1998 to June 2002. Prior to the spin-off of Crestline Capital from Host Marriott Corporation, Mr. Francis held various finance and strategic planning positions with Host Marriott and Marriott International, Inc. From June 1997 to December 1998, Mr. Francis held the position of Assistant Treasurer and Vice President Corporate Finance for Host Marriott, where he was responsible for Host Marriott’s corporate finance function, business strategy and investor relations. Over a period of ten years, Mr. Francis served in various capacities with Marriott International’s lodging business, including Vice President of Finance for Marriott Lodging from 1995 to 1997; Brand Executive, Courtyard by Marriott from 1994 to 1995; Controller for the Courtyard by Marriott and Fairfield Inn businesses from 1993 to 1994; Director of Finance and Strategic Planning for Courtyard by Marriott and Fairfield Inn from 1991 to 1993; and Director of Hotel Development Finance from 1987 to 1991. While at Host Marriott, Mr. Francis led the negotiations and structurings of leases on $8 billion of hotel assets. Mr. Francis received his B.A. in Economics and Business from Western Maryland College and earned an M.B.A. in Finance and Accounting from Vanderbilt University.

Tracy M.J. Colden is our Executive Vice President, General Counsel and Secretary, and has served in this capacity since our formation. Ms. Colden served as the Executive Vice President, General Counsel and Secretary of Barceló Crestline from June 2002 to December 2003, and served as Senior Vice President, General Counsel and Secretary of Crestline Capital Corporation, prior to its acquisition by Barceló, from December 1998 to June 2002. Prior to the spin-off of Crestline Capital from Host Marriott Corporation, Ms. Colden held various positions with Host Marriott. She joined Host Marriott in 1996 as an attorney, was promoted to Senior Attorney and again promoted to Assistant General Counsel, a capacity in which she served until joining Crestline Capital at the time of the spin-off. While at Host Marriott, Ms. Colden was responsible for negotiating and structuring debt and equity financing for inclusion in rated debt securitizations and conventional mortgage financings, as well as negotiating and structuring asset acquisitions and dispositions. Before joining Host Marriott, Ms. Colden was an associate in the real estate practice group with the law firm of Hogan & Hartson L.L.P. in Washington, D.C., from October 1988 to December 1995. Ms. Colden earned a B.B.A. from the University of Michigan School of Business, and a J.D. from the University of Virginia School of Law. She is a Certified Public Accountant and a member of the District of Columbia and Michigan state bars.

Patrick W. Campbell is our Executive Vice President and Chief Investment Officer, a position he has held since our formation. Mr. Campbell served as Senior Vice President of Acquisitions of Crestline Hotels & Resorts, Inc., an independent hotel management company and a wholly-owned subsidiary of Barceló Crestline Corporation, from January 2003 to December 2003, and served as Vice President-Business Development of Crestline Capital Corporation from July 2000 to December 2002. In his capacity with Crestline Hotels & Resorts, Mr. Campbell was responsible for developing the company’s portfolio of managed hotels through asset acquisitions, new hotel development and acquisition of management contracts. Before joining Crestline Capital, Mr. Campbell held the positions of Vice President—Acquisitions and Development with Bristol Hotels & Resorts, Inc., prior to its being acquired by Bass PLC (now Intercontinental Hotels Group). During his tenure with Bristol Hotels & Resorts, Bristol Hotels & Resorts grew from 36 hotels to over 120 hotels. Mr. Campbell held various other positions with Bristol Hotels & Resorts, including Vice President—Revenue Management from 1997 to 1998, and Vice President–Operations from 1995 to 1997. Mr. Campbell received his B.S. in Hospitality Administration from Cornell University’s School of Hotel Administration.

Douglas W. Vicari is our Executive Vice President, Chief Financial Officer and Treasurer, a position he has held since September 2003. Previously, Mr. Vicari served as Senior Vice President and Chief Financial Officer of Prime Hospitality Corp. from August 1998 to July 2003. He has served on the board of directors of Prime Hospitality from May 1999 to July 2003. In his capacity as Senior Vice President and Chief Financial Officer of Prime Hospitality, Mr. Vicari was responsible for all finance and legal functions of the company. Prior to his appointment to Chief Financial Officer, he served as Vice President and Treasurer of Prime Hospitality from

10

Table of Contents

January 1991 to July 1998 and was an instrumental member of the management team that led the company out of bankruptcy in July 1992. From 1986 to 1991, Mr. Vicari was Director of Budgeting and Financial Planning for Prime Hospitality and was responsible for all budgeting, planning and forecasting. Prior to his tenure at Prime Hospitality, Mr. Vicari held numerous management roles at Combustion Engineering (now ABB Brown Boveri) in Stamford, Connecticut from 1981 to 1986. Mr. Vicari earned a B.S. in Accounting from the College of New Jersey and received his M.B.A. in Finance from Fairleigh Dickinson University.

Available Information

We maintain an Internet site, http://www.highlandhospitality.com, which contains additional information concerning Highland Hospitality Corporation. We make available free of charge through our Internet site our filings with the Securities and Exchange Commission as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. We also post on this website our Code of Business Conduct and Ethics, Principles of Corporate Governance, and the charters of our Audit, Compensation Policy, and Nominating and Corporate Governance Committees of our board of directors. We intend to disclose on our website any changes to, or waivers from, our Code of Business Conduct and Ethics. Information on our Internet site is neither part of nor incorporated into this Form 10-K.

Item 2.    Properties

As of March 9, 2004, we owned the following seven hotel properties:

Portsmouth Renaissance and Conference Center—The 250-room Portsmouth Renaissance hotel and conference center is located at 425 Water Street, along the historic waterfront of Olde Towne in Portsmouth, Virginia. The hotel overlooks the Elizabeth River toward the skyline of neighboring Norfolk, Virginia and is located approximately twenty minutes from Norfolk International Airport. The adjoining waterfront conference center offers over 24,000 square feet of meeting space and houses a 70-seat amphitheater with video conferencing and interactive computer training capabilities. This hotel was developed as part of a public/private joint venture in 2001 and was built as a first-class hotel with impressive wood finishes, beautiful views of the water and an impressive exterior design. The hotel won Marriott International’s Renaissance Hotel Opening of the Year Award in 2001.

The Portsmouth Renaissance hotel and the adjoining conference center are leased from the Industrial Development Authority of the City of Portsmouth pursuant to two separate lease agreements, each for an initial term of 50 years ending May 2049, with four ten-year renewal options and one nine-year renewal option. Base rent under the hotel lease is $0.05 million per year. Annual percentage rent is equal to 100% of available net cash flow after payment of all hotel operating expenses, the base rent, real estate and property taxes, insurance and a cumulative priority annual return to the lessee of approximately $2 million, up to $0.2 million, then 50% of any remaining net cash flow until the landlord has been paid percentage (and additional) rent of $10 million in aggregate, and thereafter 10% of net cash flow annually. If we sell or assign the hotel lease to an unrelated party, an additional rent payment equal to 50% of the net sales proceeds in excess of our capital investment in the hotel and unpaid annual return of 15% on the investment will be due.

11

Table of Contents

Annual rent under the conference center lease is equal to the lesser of $0.075 million per year or the maximum amount of rent allowable under tax regulations so as to preserve the tax-exempt status of the Portsmouth Industrial Development Authority bonds issued in connection with the hotel and conference center.

Plaza San Antonio Marriott—The 252-room Plaza San Antonio Marriott hotel is situated on over 6.2 acres of landscaped grounds near San Antonio’s famed River Walk and is directly across the street from the city’s convention center. The hotel’s downtown location provides convenient access to the Alamo Dome, La Villita (the village of Old San Antonio), the downtown financial district and the King William District, a historic Victorian preserve of homes, shops and restaurants.

The Plaza San Antonio Marriott hotel opened in 1979, contains over 16,000 square feet of meeting space, and offers such amenities as spa treatments, a sauna and whirlpool, and a heated outdoor swimming pool. In addition to the hotel ballroom of 6,100 square feet, the hotel utilizes two historic structures known as the German American School, which are located on the hotel grounds, and now serve as the hotel’s conference center. The conference center is leased from the City of San Antonio and is in the second of four permitted ten-year renewal options. In 2004, we intend to spend approximately $5.5 million on renovations in the hotel’s guest rooms, bathrooms, corridors and restaurant.

Hyatt Regency Savannah—The 351-room Hyatt Regency Savannah hotel is centrally located on the Savannah River in Savannah, Georgia. The hotel’s convenient location adjacent to the landmark gold-domed City Hall makes it accessible to the city’s leisure and business attractions. The hotel features 36,000 square feet of meeting space, including an 11,000 square foot exhibit hall with river views, an 8,000 square foot ballroom and a restaurant and lounge with spectacular river views. Savannah has evolved into one of the nation’s leading tourist destinations. Condé Nast Traveler magazine recently ranked Savannah as one of the top ten United States cities to visit and sixth most popular tourist destination in the United States. The downtown area, with its historical squares and parks, attracts an estimated 6.5 million visitors annually, contributing nearly $1 billion to the local economy.

The Hyatt Regency Savannah hotel opened in 1981. In 2004, we intend to spend approximately $7.5 million on renovations in the hotel’s guest rooms, restaurant, lounge and lobby.

Sugar Land Marriott and Conference Center—The 300-room Sugar Land Marriott hotel and conference center, which is located at 16090 City Walk, Sugar Land, Texas, opened in October 2003. Sugar Land is an affluent suburb of Houston, Texas and is approximately 15 miles from the Houston Galleria and 20 miles from downtown. The Sugar Land Marriott hotel is the centerpiece hotel in Sugar Land Town Square, a 32-acre mixed-use development that is planned to include over 600,000 square feet of Class A office space, Sugar Land’s City Hall, upscale retail shops, residential space, restaurants and a conference center. The hotel has 25,500 square feet of meeting space, including a 15,500 square foot ballroom, the third largest in the City of Houston.

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

Hilton Garden Inn Virginia Beach Town Center—The 176-room Hilton Garden Inn Virginia Beach Town Center hotel, which is located at 252 Town Center Drive, Virginia Beach, Virginia, opened in November 2003. The hotel is part of Virginia Beach’s public/private town center development which will span over 17 blocks and will be located at the core of the city’s emerging central business district. The town center will provide a mix of Class A office space, multi-level upscale retail, deluxe residential components, a performing arts center and an array of cafes and restaurants, along with the Hilton Garden Inn Virginia Beach Town Center hotel. The hotel provides 6,000 square feet of meeting space to service small groups.

12

Table of Contents

Hilton Tampa Westshore—The 238-room Hilton Tampa Westshore hotel is located approximately five minutes from the Tampa International Airport. The hotel features approximately 12,000 square feet of meeting space. The hotel also features such amenities as a landscaped gazebo area with a large heated pool and whirlpool, a lighted tennis court, a newly equipped fitness center and shuttle service to both the airport and the Port of Tampa. The hotel opened in 1982, and in 2003, a $4.5 million rooms and lobby renovation was completed.

Hilton Garden Inn Baltimore/Washington International (BWI) Airport—The 158-room Hilton Garden Inn BWI Airport hotel is strategically located near the Baltimore/Washington International Airport which services both the Baltimore, Maryland and Washington, D.C. metropolitan areas and has seen extensive growth from the increasing popularity of discount airlines, such as Southwest Airlines and AirTran which serve the airport, and an expanding international terminal. The Hilton Garden Inn BWI Airport hotel opened in June 2001 and is located within minutes of the airport and within eight miles of Baltimore’s downtown area. The hotel contains over 2,000 square feet of meeting space and provides such amenities as complimentary high-speed internet access, a pool and fitness room and airport shuttle transportation.

Item 3.    Legal Proceedings

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

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

No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year ended December 31, 2003.

13

Table of Contents

PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters

Market Information

Our common stock trades on the New York Stock Exchange under the symbol “HIH”. The following table sets forth, for the indicated period, the high and low closing prices for the common stock, as reported on the New York Stock Exchange:

The closing price of our common stock on the New York Stock Exchange on March 9, 2004 was $12.30 per share.

Stockholder Information

As of March 9, 2004, there were 25 record holders of our common stock, including shares held in “street name” by nominees who are record holders, and approximately 5,146 beneficial owners.

In order to comply with certain requirements related to our qualification as a REIT, our charter, subject to certain exceptions, limits the number of common shares that may be owned by any single person or affiliated group to 9.9% of the outstanding common shares.

Use of Proceeds from Registered Securities

The date of the IPO of our common stock was December 16, 2003. The managing underwriters of the IPO were Friedman, Billings, Ramsey & Co., Inc., Deutsche Bank Securities, Inc. and Raymond James & Associates, Inc. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Form S-11 Registration Statement (SEC File No. 333-108671) that was declared effective by the Securities and Exchange Commission on December 15, 2003. The offering was closed on December 19, 2003. All 30,000,000 shares of common stock registered under the registration statement were sold at a price to the public of $10 per share. As part of the IPO, we granted the underwriters an over-allotment option to purchase up to an additional 4,500,000 shares of our common stock. The underwriters exercised their option in full on December 26, 2003. The aggregate gross proceeds from the shares of common stock sold by us were $345 million. The aggregate net proceeds to us from the offering were approximately $318.9 million after deducting approximately $24.1 million in underwriting discounts and approximately $2 million in other expenses incurred in connection with the offering. All of the shares of common stock were sold by us and there were no selling stockholders in the offering.

We used approximately $180 million of the net proceeds to purchase our initial portfolio of seven hotels (five hotels were acquired by December 31, 2003 and another two were acquired within the first two weeks of 2004). We intend to use the remaining net proceeds to acquire additional hotel properties and for general corporate purposes. Pending the use of the proceeds, as described above, we will invest any remaining proceeds in short-term, investment-grade, interest-bearing securities.

Unregistered Securities

Private Placements—Concurrent with the IPO, we sold in private placement transactions an aggregate of 4,550,000 shares of common stock at a price per share equal to the IPO price, less an amount equal to the underwriting discount of $0.70 per share. We have agreed to register these shares with the Securities and Exchange Commission for resale by the purchasers thereof prior to December 19, 2004.

14

Table of Contents

Warrants—In connection with the IPO, we granted to our underwriters, as partial consideration for its services, warrants representing the right to acquire 888,488 shares of common stock. The warrants are exercisable for a period of five years commencing December 19, 2003 at an exercise price of $10 per share. We have reserved 888,488 shares of common stock for issuance upon exercise of the warrants and have agreed to register with the Securities and Exchange Commission prior to December 19, 2004, the shares of common stock underlying the warrants.

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 our common stock on a one-for-one basis or, at our option, cash per unit equal to the market price of our 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 our stockholders. As of December 31, 2003, the total number of Operating Partnership units outstanding was 953,719. We have agreed to register with the Securities and Exchange Commission prior to December 19, 2004, 953,719 shares of our common stock that are issuable upon redemption of the Operating Partnership units; however, the 953,719 Operating Partnership units cannot be redeemed prior to December 19, 2004.

The common shares sold in the private placements, the warrants, and Operating Partnership units were issued in reliance on the exemption set forth in Section 4(2) of the Securities Act and Rule 506 of Regulation D thereunder.

Dividend and Distribution Information

To maintain our qualification as a REIT, we intend to make annual distributions to our stockholders of at least 90% of our taxable income excluding net capital gains (which does not necessarily equal net income as calculated in accordance with accounting principles generally accepted in the United States of America). The timing and frequency of distributions will be authorized by our board of directors and declared by us based upon a variety of factors deemed relevant by our directors. Our ability to pay distributions to our stockholders will depend, in part, upon our receipt of distributions from our Operating Partnership, which will depend upon receipt of rent payments with respect to our properties from our TRS lessees and the management of our hotel properties by Barceló Crestline, Hyatt Corporation and other hotel management companies that our TRS lessees will engage to operate our hotels. Distributions to our stockholders generally will be taxable to our stockholders as ordinary income; however, because a significant portion of our investments will be equity ownership interests in hotel properties, which will result in depreciation and non-cash charges against our income, a portion of our distributions may constitute a tax-free return of capital. To the extent consistent with maintaining our REIT status, our taxable REIT subsidiary and TRS lessees may retain any after-tax earnings.

Item 6.    Selected Financial Data

The following table sets forth selected historical financial data for Highland Hospitality Corporation beginning with its commencement of operations on December 19, 2003. Prior to December 19, 2003, the table sets forth selected historical financial data for Portsmouth Hotel Associates, LLC, which was acquired by us concurrent with the completion of our IPO on December 19, 2003. Portsmouth Hotel Associates, LLC was owned 66.7% by Barceló Crestline, which was the sponsor of our formation and IPO. Portsmouth Hotel Associates, LLC is considered the predecessor to Highland Hospitality Corporation for accounting purposes. Portsmouth Hotel Associates, LLC, which leases the Portsmouth Renaissance hotel and conference center, commenced operations on January 10, 2001. Portsmouth Hotel Associates, LLC activity prior to January 10, 2001 related to construction and pre-opening efforts.

15

Table of Contents

The selected historical financial data for Highland Hospitality Corporation for the period from December 19, 2003 through December 31, 2003, and the selected historical financial data for Portsmouth Hotel Associates, LLC for the period from January 1, 2003 through December 18, 2003 and for the years ended December 31, 2002, 2001, 2000 and 1999 have been derived from the historical financial statements of Highland Hospitality Corporation and Portsmouth Hotel Associates, LLC. The following selected historical financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements and notes thereto, both included elsewhere in this Form 10-K.

HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

SELECTED HISTORICAL FINANCIAL DATA

(in thousands, except per share data)

16

Table of Contents

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

17

Table of Contents

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive Summary

Although our operating results for 2003 only reflect 13 days of activity, we believe that we have accomplished much in a short period of time. We successfully completed our IPO on December 19, 2003. As a result of the IPO, as well as the underwriters’ exercise of their over-allotment option and private placement transactions, we raised net proceeds of approximately $361.2 million. We immediately utilized the proceeds to purchase our initial portfolio of seven hotels (five hotels were acquired by December 31, 2003 and another two were acquired within the first two weeks of 2004). After the completion of seven hotel acquisitions, we still have approximately $180 million to use to acquire additional hotel properties. We are actively, yet prudently, looking for opportunities to invest our capital in hotel properties that will maximize returns for our stockholders over the long term. We are also currently in negotiations with several financial institutions to obtain a line of credit which will enable us to expand our investment capacity. However, maintaining a strong balance sheet with moderate leverage will always be an important focus of ours.

In the second half of 2003, after two and one half years of extremely poor operating performance, we began to see signs of solid recovery in our industry, including a recovery in the United States economy, a rebound in consumer confidence, and increased demand for hotel rooms by both business and leisure travelers. We believe that these factors, combined with very limited supply growth, strongly position our industry for economic recovery over the next several years. Revenue growth is expected to be 5% industry-wide in 2004 and, with the operating leverage inherent in our business, profits will expand. We believe that we are well positioned given our financial resources and extensive executive experience and relationships within the lodging industry to take advantage of the opportunities in a rebounding industry.

Overview

Highland Hospitality Corporation is a self-advised REIT that was incorporated in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside the United States. We commenced operations on December 19, 2003 when we completed our IPO and concurrently consummated the acquisition of three hotel properties.

The IPO consisted of the sale of 30,000,000 shares of common stock, resulting in net proceeds (after deducting underwriting discounts and offering expenses) of approximately $277 million. In conjunction with the IPO, we sold an additional 9,050,000 shares of common stock as a result of private placement transactions and the exercise of the underwriters’ over-allotment option, resulting in additional proceeds of approximately $84.2 million. The total net proceeds generated from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option were approximately $361.2 million.

Our initial three hotel properties were acquired from entities that were partially owned by Barceló Crestline, which was the sponsor of our formation and IPO. We used approximately $61.9 million of net proceeds from the IPO and issued 953,719 units of our Operating Partnership to acquire all of the equity interests in the three entities. The equity interests in the three entities acquired from Barceló Crestline, as our sponsor, in exchange for Operating Partnership units have been accounted for as a reorganization of entities under common control and recorded at Barceló Crestline’s historical cost basis. The remaining equity interests in the three entities acquired from third parties have been accounted for as acquisitions of minority interests and recorded at fair value.

On December 29, 2003 and December 30, 2003, we acquired two additional hotel properties for an aggregate purchase price of approximately $81.9 million. We have accounted for the acquisition of the two hotel properties under the purchase method of accounting, recording these hotels at their acquisition costs. As of December 31, 2003, we owned five hotel properties.

18

Table of Contents

Substantially all of our assets are held by, and all of our operations are conducted through our Operating Partnership. In order for us to qualify as a REIT, neither our company nor the Operating Partnership can operate hotels directly. Therefore, the Operating Partnership, which is owned 97.7% by us and 2.3% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly-owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels under management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

The discussion below relates to Highland Hospitality Corporation as of December 31, 2003 and for the period from December 19, 2003 (commencement of operations) through December 31, 2003. Prior to December 19, 2003, the discussion below relates to Portsmouth Hotel Associates, LLC, which was one of the three entities we acquired on December 19, 2003 and partially owned by Barceló Crestline. Portsmouth Hotel Associates, LLC is considered the predecessor to Highland Hospitality Corporation for accounting purposes. Securities and Exchange Commission regulations require the inclusion of predecessor financial information for the periods prior to Highland Hospitality Corporation’s commencement of operations.

Results of Operations

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

Occupancy is a major driver of room revenue as well as other revenue categories such as food and beverage and telephone. ADR helps to drive room revenue as well; however, it does not have a direct effect on other revenue categories. Fluctuations in occupancy are accompanied by fluctuations in most categories of variable operating costs, such as franchise fees, utility costs and certain labor costs such as housekeeping, resulting in varying levels of hotel profitability. Increases in ADR typically result in higher hotel profitability since variable hotel expenses generally do not increase correspondingly. Thus, increases in RevPAR attributable to increases in occupancy are accompanied by increases in most categories of variable operating costs, while increases in RevPAR attributable to increases in ADR are accompanied by increases in limited categories of operating costs, such as management fees and franchise fees.

Highland Hospitality Corporation—Period from December 19, 2003 through December 31, 2003

Results of operations for the period from December 19, 2003 through December 31, 2003 include the operating activity of three hotels for 13 days, one hotel for three days, and one hotel for two days. The results of operations for the period from December 19, 2003 through December 31, 2003 are not indicative of future operating results for the five hotels, as the fourth quarter, in particular the weeks before and after the Christmas holiday, are traditionally slower periods for business and leisure travel.

Revenue—Revenues for the period from December 19, 2003 through December 31, 2003 were $0.7 million, which included rooms revenue of $0.3 million and food and beverage revenue of $0.3 million. Average occupancy, ADR, and RevPAR for the period from December 19, 2003 through December 31, 2003 were 32.2%, $99.47, and $31.99, respectively.

Expenses—Total hotel operating expenses, excluding depreciation and amortization, for the period from December 19, 2003 through December 31, 2003 was $0.8 million. Depreciation and amortization for the period from December 19, 2003 through December 31, 2003 was $0.1 million. Total corporate and general administrative expenses for the period from December 19, 2003 through December 31, 2003 were $2.9 million. Included in corporate and general expenses were one-time charges related to our IPO. These charges included $0.5 million related to director stock-based compensation and $2 million related to start-up costs and reimbursements to Barceló Crestline, which was the sponsor of our formation and IPO.

19

Table of Contents

Operating loss for the period from December 19, 2003 through December 31, 2003 was $(3.1) million, largely due to the items discussed above.

Interest income and the minority interest in our operating partnership for the period from December 19, 2003 through December 31, 2003 were $0.07 million and $0.06 million, respectively. As a result of our operating losses for the period from December 19, 2003 through December 31, 2003, we recorded an income tax benefit of $0.3 million. Net loss for the period from December 19, 2003 through December 31, 2003 was $(2.7) million.

Portsmouth Hotel Associates, LLC—Comparison of period from January 1, 2003 through December 18, 2003 to year ended December 31, 2002

With respect to the following discussion of revenues and expenses, note that a part of the reason for the decrease in revenues and expenses is due to the fact that the results of operations for 2003 include Portsmouth Hotel Associates, LLC’s activity for the period from January 1, 2003 through December 18, 2003 (352 days), whereas the 2002 results of operations include the full year.

Revenue—Room revenues decreased $0.2 million, or 3.4%, for the period from January 1, 2003 through December 18, 2003, as compared to the year ended December 31, 2002, largely the result of decreased room demand. This decrease is primarily due to the major deployment of military forces to Iraq and the impact of hurricane Isabel in mid-September 2003. Average occupancy decreased from 68.8% for the year ended December 31, 2002 to 67.4% for the period from January 1, 2003 through December 18, 2003. ADR increased 2.1%, improving from $97.27 for the year ended December 31, 2002 to $99.38 for the period from January 1, 2003 through December 18, 2003. RevPAR increased to $67.01 for the period from January 1, 2003 through December 18, 2003 from $66.93 for the year ended December 31, 2002. Food and beverage revenue decreased $0.03 million, or 0.6%, for the period from January 1, 2003 through December 18, 2003, as compared to the year ended December 31, 2002. Total revenues decreased $0.2 million, or 2%, for the period from January 1, 2003 through December 18, 2003, as compared to the year ended December 31, 2002, mainly due to the decreases in room and food and beverage revenues described above.

Expenses—Total hotel operating expenses, excluding depreciation and amortization, decreased $0.07 million, or 0.8%, for the period from January 1, 2003 through December 18, 2003 as compared to the year ended December 31, 2002. Depreciation and amortization was $0.7 million for both the period from January 1, 2003 through December 18, 2003 and the year ended December 31, 2002. Interest expense increased $0.02 million, or 2%, for the period from January 1, 2003 through December 18, 2003, as compared to the year ended December 31, 2002. The increase was due primarily to the write-off of deferred financing costs in connection with the acquisition of Portsmouth Hotel Associates, LLC by Highland Hospitality Corporation, offset by lower interest rates in 2003.

Operating profit decreased $0.1 million for the period from January 1, 2003 through December 18, 2003, as compared to the year ended December 31, 2002. Net loss was $0.1 million for the period from January 1, 2003 through December 18, 2003, as compared to net income of $0.07 million for the year ended December 31, 2002, due to the items discussed above.

Portsmouth Hotel Associates, LLC—Comparison of year ended December 31, 2002 to year ended December 31, 2001

Revenue—Room revenues increased $1.2 million, or 25.2%, for the year ended December 31, 2002, as compared to the year ended December 31, 2001. The Portsmouth Renaissance hotel opened in January 2001. During a substantial portion of 2001, the hotel was in a ramp-up phase following the opening. A military build up in 2002 in anticipation of war with Iraq helped to support this market with a large military presence. Overall, our occupancy increased from 58.3% for the year ended December 31, 2001 to 68.8% for the year ended

20

Table of Contents

December 31, 2002. Our ADR increased 3.4% from $94.03 for the year ended December 31, 2001 to $97.27 for the year ended December 31, 2002. Consequently, our RevPAR increased 22.1% from $54.83 for the year ended December 31, 2001 to $66.94 for the year ended December 31, 2002. Food and beverage revenue increased $0.3 million, or 7.8%, from 2001 to 2002, also mainly due to the new hotel settling in the marketplace. Total revenues increased 15.7% from 2001 to 2002.

Expenses—Hotel operating costs and expenses, excluding depreciation and amortization and pre-opening costs, increased by $0.7 million, or 7.8%, for the year ended December 31, 2002 compared to the year ended December 31, 2001. This increase in hotel operating expenses can be attributed to the increase in business activity during the hotel’s second year of operations. Depreciation and amortization was comparable between 2002 and 2001 as there were few capital expenditures after January 10, 2001 when the hotel opened. Interest expense was $1 million in 2002 as compared to $1.1 million in 2001, due primarily to lower interest rates.

Operating profit in 2002 increased to $1 million as compared to operating profit of $0.06 million in 2001. Net income was $0.07 million in 2002 compared to a net loss of $1 million in 2001 due to the items discussed above.

Portsmouth Hotel Associates, LLC—Comparison of year ended December 31, 2001 to year ended December 31, 2000

Revenue—Since the hotel was not open in 2000, there are no historical revenues for 2000.

Expenses—Operating expenses consisted of pre-opening costs related to the opening of the hotel, such as organizational and general and administrative costs, including personnel costs and legal fees. Pre-opening costs decreased $1.3 million, or 90%, for the year ended December 31, 2001 as compared to 2000 as a result of the property opening in January 2001.

There was no depreciation and amortization in 2000 as the hotel was under construction and all interest costs were capitalized in 2000.

Liquidity and Capital Resources

As of December 31, 2003, we had cash and cash equivalents of approximately $225.6 million. In January 2004, we acquired two additional hotel properties using approximately $35.9 million of the cash and cash equivalents on hand at December 31, 2003. We intend to use the remaining proceeds from the IPO, the underwriters’ exercise of their over-allotment option, and the private placement transactions to invest in additional hotel properties as suitable opportunities arise.

We expect to meet our short-term liquidity requirements generally through net cash provided by operations, existing cash balances and, if necessary, short-term borrowings under anticipated lines of credit. We believe that our net cash provided by operations will be adequate to fund operating requirements, including planned renovations, pay interest on borrowings, and fund dividends in accordance with the REIT requirements of the federal income tax laws.

We intend to incur indebtedness to supplement our investment capital. While our charter does not limit the amount of debt we can incur, to maintain flexibility to respond to industry conditions and opportunities, we intend to maintain target debt levels of 40-50% of historical asset cost. We are currently in negotiations with a number of financial institutions to obtain a line of credit. Beyond our anticipated line of credit, we intend to use other financing methods as necessary, including obtaining from banks, institutional investors or other lenders, financings through property mortgages, bridge loans, letters of credit, and other arrangements, any of which may be unsecured or may be secured by mortgages or other interests in our investments. In addition, we may issue publicly or privately placed debt instruments. When possible and desirable, we will seek to replace short-term sources of capital with long-term financing.

21

Table of Contents

Capital Expenditures

We will maintain each hotel in good repair and condition and in conformity with applicable laws and regulations and in accordance with the franchisor’s standards and the agreed upon requirements in our management agreements. The cost of all such routine maintenance, repairs and alterations will be paid out of a furniture, fixtures and equipment reserve, which will be funded by a portion of hotel gross revenues. Routine repairs and maintenance will be administered by the management company. However, we will have approval rights over capital expenditures. In 2004, we plan to spend approximately $13 million on renovations at two of our hotel properties.

Contractual Obligations

The following table sets forth our contractual obligations at December 31, 2003, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands). There were no other off-balance sheet arrangements at December 31, 2003.

Inflation

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

Seasonality

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

Critical Accounting Policies

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

Investment in Hotel Properties—Investments in hotel properties are stated at acquisition cost (except where interests are acquired from Barceló Crestline) and allocated to land, property and equipment and identifiable intangible assets at fair value in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Property and equipment are recorded at current replacement cost for similar capacity and allocated to buildings, improvements, furniture, fixtures and equipment based on cost segregation studies

22

Table of Contents

performed by management and independent third parties. Property and equipment are depreciated using the straight-line method over an estimated useful life of 15 to 40 years for buildings and improvements and three to ten years for furniture and equipment. Identifiable intangible assets are typically contracts, including lease agreements and franchise agreements, which are recorded at fair value. Above-market and below-market lease values are based on the present value of the difference between contractual amounts to be paid pursuant to the leases acquired and our estimate of the fair market lease rates for corresponding leases measured over a period equal to the remaining non-cancelable term of the lease. Leases acquired which are at market do not have significant value. An existing franchise agreement is typically terminated at the time of acquisition and a new franchise agreement is entered into based on then current market terms. Above-market and below-market franchise agreement values are based on the present value of the difference between contractual amounts to be paid pursuant to the franchise agreements acquired and our estimate of the fair market franchise rates for corresponding franchise agreements measured over a period equal to the remaining non-cancelable term of the franchise agreement. Franchise agreements acquired which are at market do not have significant value because they are easily transferable with minimal cost. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired.

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

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

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

New Accounting Pronouncements

FASB Interpretation No. 45 (“FIN 45”), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The adoption of FIN 45 did not have a material impact on our results of operations, financial position, or cash flows.

FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51, as amended (“FIN 46R”), requires certain variable interest entities to be consolidated

23

Table of Contents

by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The adoption of FIN 46R did not have a material impact on our results of operations, financial position, or cash flows.

Statement of Financial Accounting Standards No. 150 (“SFAS 150”), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of these financial instruments were classified as equity. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period after June 15, 2003. However, in October 2003, the FASB elected to indefinitely defer implementation of certain provisions of SFAS 150 relating to limited-life subsidiaries created before November 5, 2003. The adoption of SFAS 150 did not have a material impact on our results of operations, financial position, or cash flows.

Item 7a.    Quantitative and Qualitative Disclosures About Market Risk

As of December 31, 2003, we did not have any financial instruments that were exposed to market risk. Our financial instruments included cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses. Due to their short maturities, these financial instruments are carried at amounts that reasonably approximate fair value.

Item 8.    Financial Statements and Supplementary Data

See Index to the Financial Statements on page F-1.

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9a.    Controls and Procedures

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

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

24

Table of Contents

PART III

The information required by Items 10-14 is incorporated by reference to our proxy statement for the 2004 annual meeting of stockholders (to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this report).

Item 10.    Directors and Executive Officers of the Registrant

Information on our directors is incorporated by reference to our 2004 proxy statement. Information on our executive officers is included under the heading “Executive Officers” on pages 9 through 11 of this report.

Item 11.    Executive Compensation

The information required by this item is incorporated by reference to our 2004 proxy statement.

Item 12.    Security Ownership of Certain Beneficial Owners and Management

The information required by this item is incorporated by reference to our 2004 proxy statement.

Item 13.    Certain Relationships and Related Transactions

The information required by this item is incorporated by reference to our 2004 proxy statement.

Item 14.    Principal Accounting Fees and Services

The information required by this item is incorporated by reference to our 2004 proxy statement.

25

Table of Contents

PART IV

Item 15.    Exhibits, Financial Statement Schedules, and Reports on Form 8-K

Included herein at pages F-1 through F-19.

The following financial statement schedule is included herein at page F-20:

Schedule III – Real Estate and Accumulated Depreciation

All other schedules for which provision is made in Regulation S-X are either not required to be included herein under the related instructions or are inapplicable or the related information is included in the footnotes to the applicable financial statement and, therefore, have been omitted.

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

26

Table of Contents

27

Table of Contents

28

Table of Contents

SIGNATURES

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.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

29

Table of Contents

HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

AS OF DECEMBER 31, 2003 AND 2002

INDEX TO FINANCIAL STATEMENTS

F-1

Table of Contents

Independent Auditors’ Report

The Board of Directors

Highland Hospitality Corporation:

We have audited the accompanying consolidated balance sheet of Highland Hospitality Corporation and subsidiaries (Successor) as of December 31, 2003, and of Portsmouth Hotel Associates, LLC (Predecessor) as of December 31, 2002, and the related consolidated statements of operations, owners’ equity, and cash flows for the period from December 19, 2003 to December 31, 2003 (Successor period), and the related statements of operations, owners’ equity, and cash flows for the period from January 1, 2003 to December 18, 2003 and for each of the years in the two-year period ended December 31, 2002 (Predecessor periods). In connection with our audit of the consolidated financial statements of the Successor, we have also audited the related financial statement Schedule III. These financial statements and financial statement schedule are the responsibility of the Companies’ management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the aforementioned Successor consolidated financial statements present fairly, in all material respects, the financial position of Highland Hospitality Corporation and subsidiaries as of December 31, 2003, and the results of their operations and their cash flows for the Successor period, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. Further, in our opinion, the aforementioned Predecessor financial statements present fairly, in all material respects, the financial position of Portsmouth Hotel Associates, LLC as of December 31, 2002, and the results of its operations and its cash flows for the Predecessor periods, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 3 to the consolidated financial statements, effective December 19, 2003, Highland Hospitality Corporation acquired all of the outstanding equity interests of Portsmouth Hotel Associates, LLC in a business combination accounted for as a reorganization of entities under common control with respect to the interests acquired from Barceló Crestline Corporation and acquisition of minority interests recorded at fair value from third parties. As a result of the acquisition, the consolidated financial information for the period after the acquisition is presented on a different cost basis than for the periods before the acquisition and, therefore, is not comparable.

/s/ KPMG LLP

McLean, Virginia

February 28, 2004

F-2

Table of Contents

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEET

AND PREDECESSOR BALANCE SHEET

(in thousands, except share data)

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

F-3

Table of Contents

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF OPERATIONS

AND PREDECESSOR STATEMENTS OF OPERATIONS

(in thousands, except per share data)

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

F-4

Table of Contents

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF OWNERS’ EQUITY

AND PREDECESSOR STATEMENTS OF OWNERS’ EQUITY

(in thousands, except share data)