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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

For the transition period from              to              .

Commission file number 001-31906

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

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

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

As of November 12, 2004, there were 40,002,011 shares of the registrant’s common stock issued and outstanding.

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HIGHLAND HOSPITALITY CORPORATION

INDEX

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PART I

Item 1. Financial Statements

HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

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

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HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

AND PREDECESSOR STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

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

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HIGHLAND HOSPITALITY CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

AND PREDECESSOR STATEMENT OF CASH FLOWS

(in thousands)

(unaudited)

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

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

1. Organization and Description of Business

Highland Hospitality Corporation (the “Company”) is a self-advised real estate investment trust (“REIT”) that was incorporated in Maryland in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside the United States. The Company commenced operations on December 19, 2003 when it completed its initial public offering (“IPO”) and concurrently consummated the acquisition of three hotel properties (“initial 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, the Company 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, the Company 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 was approximately $361.2 million.

The Company contributed all of the net proceeds from the IPO, the private placement transactions, and the exercise of the underwriters’ over-allotment option to Highland Hospitality, L.P., a Delaware limited partnership (the “Operating Partnership”), in exchange for an approximate 98% general and limited partnership interest in the Operating Partnership. The Operating Partnership used approximately $61.9 million of the net proceeds from the Company, along with 967,211 units of limited partner interest, to acquire all of the equity interests in the entities that own or lease the initial properties.

Since the IPO and the acquisition of the initial properties on December 19, 2003, the Operating Partnership has acquired 14 hotel properties (two in December 2003 and 12 in 2004) for an aggregate purchase price of approximately $523.5 million, including the assumption of mortgage debt of approximately $28.3 million. As of September 30, 2004, the Company owned 17 hotel properties.

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

2. Summary of Significant Accounting Policies

Basis of Presentation—The Company’s consolidated financial statements presented herein include all of the accounts of Highland Hospitality Corporation as of and for the quarter and nine months ended September 30, 2004. For the quarter and nine months ended September 30, 2003, this report includes the financial statements of Portsmouth Hotel Associates, LLC (“PHA”), which was one of the three entities acquired by the Company concurrent with the completion of the IPO on December 19, 2003. PHA was owned 66.7% by Barceló Crestline Corporation (“Barceló Crestline”), which was the sponsor of the Company’s formation and IPO. PHA is considered the predecessor to the Company for accounting purposes. Securities and Exchange Commission regulations require the inclusion of predecessor financial information for the periods prior to the Company’s commencement of operations. The predecessor statements of operations and cash flows for the quarter and nine months ended September 30, 2003 include the operations of PHA on its historical cost basis.

The information in these financial statements is unaudited but, in the opinion of management, reflects all adjustments necessary for a fair presentation of the results for the periods covered. All such adjustments are of a normal, recurring nature unless disclosed otherwise. These financial statements, including notes, have been prepared in accordance with the applicable rules of the Securities and Exchange Commission and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. Additional information is contained in the Highland Hospitality Corporation Form 10-K for the year ended December 31, 2003.

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

Principles of Consolidation—The accompanying Company financial statements include the accounts of Highland Hospitality Corporation and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation.

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

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

Derivative Instruments—The Company accounts for derivative instruments in accordance with the provisions of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted (“SFAS 133”). Under SFAS 133, all derivative instruments are required to be recognized as either assets or liabilities in the balance sheet and measured at fair value. Derivative instruments used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivative instruments used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. For a derivative instrument designated as a cash flow hedge, the change in fair value each period is reported in accumulated other comprehensive income in stockholders’ equity to the extent the hedge is effective. For a derivative instrument designated as a fair value hedge, the change in fair value each period is reported in earnings along with the change in fair value of the hedged item attributable to the risk being hedged. For a derivative instrument that does not qualify for hedge accounting or is not designated as a hedge, the change in fair value each period is reported in earnings. The Company does not enter into derivative instruments for speculative trading purposes.

Fair Value of Financial Instruments—The Company’s financial instruments include cash and cash equivalents, restricted cash, accounts receivable, accounts payable, accrued expenses, and long-term debt. Carrying values reported in the consolidated balance sheet for cash and cash equivalents, restricted cash, accounts receivable, accounts payable, and accrued expenses approximate fair value due to the short-term nature of these instruments. The carrying value reported in the consolidated balance sheet for long-term debt approximates fair value as a result of all but one instrument having recently been issued or assumed and recorded at fair value at that time. The remaining instrument, which matures in July 2005, approximates fair value due to the short maturity of the instrument.

Investment in Hotel Properties—Investments in hotel properties are recorded at acquisition cost (except where interests were acquired from Barceló Crestline and recorded at Barceló Crestline’s historical cost basis), and allocated to land, property and equipment and identifiable intangible assets in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Replacements and improvements are capitalized, while repairs and maintenance are expensed as incurred. Upon the sale or retirement of a fixed asset, the cost and related accumulated depreciation are removed from the Company’s accounts and any resulting gain or loss is included in the consolidated statement of operations.

Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally 15 to 40 years for buildings and building improvements and three to ten years for furniture, fixtures and equipment. Leasehold improvements are amortized over the shorter of the lease term or the useful lives of the related assets.

The Company reviews its investments in hotel properties for impairment whenever events or changes in circumstances indicate that the carrying value of the hotel properties may not be recoverable. Events or circumstances that may cause a review include, but are not limited to, adverse changes in the demand for lodging at the properties due to declining national or local economic conditions and/or new hotel construction in markets where the hotels are located. When such conditions exist, management performs an analysis to determine if the estimated undiscounted future cash flows from operations and the proceeds from the ultimate disposition of a hotel property exceed its carrying value. If the estimated undiscounted future cash flows are less than the carrying amount of the asset, an adjustment to reduce the carrying amount to the related hotel property’s estimated fair market value is recorded and an impairment loss recognized. No impairment losses have been recorded for the quarters and nine months ended September 30, 2004 and 2003.

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

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

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

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

Deferred Financing Costs—Deferred financing costs are recorded at cost and consist of loan fees and other costs incurred in issuing debt. Amortization of deferred financing costs is computed using a method that approximates the effective interest method over the term of the related debt and is included in interest expense in the consolidated statement of operations. Accumulated amortization as of September 30, 2004 was $0.1 million.

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

Income Taxes—The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code. As a REIT, the Company generally will not be subject to federal income tax on that portion of its net income (loss) that does not relate to HHC TRS, the Company’s wholly-owned taxable REIT subsidiary. HHC TRS, which leases the Company’s hotels from the Operating Partnership, is subject to federal and state income taxes.

The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“SFAS 109”). Under SFAS 109, the Company accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Valuation allowances are provided if based upon the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

PHA operated as a limited liability company and, as a result, was not subject to federal or state income taxation. Accordingly, no provision was made for federal or state income taxes in the predecessor financial statements.

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

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

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

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

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

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

Reclassifications—Certain reclassifications have been made to the predecessor financial statements to conform to the Company’s presentation.

3. Acquisition of Hotel Properties

On January 8, 2004, the Company acquired the 238-room Hilton Tampa Westshore hotel located in Tampa, Florida for approximately $30.2 million, which included the assumption of mortgage debt that encumbers the hotel property of $17 million. On January 12, 2004, the Company acquired the 158-room Hilton Garden Inn Baltimore/Washington International (BWI) Airport hotel located in Linthicum, Maryland for approximately $22.7 million. The Company entered into long-term agreements with Crestline Hotels & Resorts, Inc. to manage the two hotel properties.

On May 10, 2004, the Company acquired the 491-room Dallas/Fort Worth Airport Marriott hotel located in Dallas/Fort Worth, Texas for approximately $59.6 million. The Company assumed the existing long-term agreement with Marriott International, Inc. to manage the hotel property.

On August 2, 2004, the Company acquired the 156-room Courtyard Savannah Historic District hotel in Savannah, Georgia and the 109-room Residence Inn Tampa Downtown hotel in Tampa, Florida for approximately $38.5 million. The Company entered into long-term agreements with McKibbon Hotel Management, Inc. to manage the two hotel properties.

On August 19, 2004, the Company acquired a four-hotel portfolio, consisting of the 510-room Hilton Parsippany hotel in Parsippany, New Jersey, the 495-room Crowne Plaza Atlanta-Ravinia hotel in Atlanta, Georgia, the 360-room Wyndham Wind Watch hotel in Hauppauge, New York, and the 322-room Tremont Boston hotel in Boston, Massachusetts, for approximately $229 million. The acquisition was partially funded with a $160 million financing, comprised of a $135 million mortgage loan and a $25 million mezzanine loan. The loan provider required that the Company deposit $27.5 million in an escrow account, which amount will be used to renovate the hotel properties.

The Company entered into long-term agreements with Crestline Hotels & Resorts, Inc. to manage the Hilton Parsippany hotel and the Crowne Plaza Atlanta-Ravinia hotel. The Company converted the Wyndham Wind Watch hotel to the Hyatt Regency brand and entered into a long-term agreement with Hyatt Corporation to manage the hotel property. The Company signed a definitive agreement to convert the Tremont Boston hotel to the Courtyard brand and entered into a long-term agreement with Marriott International, Inc. to manage the hotel property.

On September 1, 2004, the Company acquired the 283-room Radisson Mount Laurel hotel for approximately $14.5 million. The Company entered into a long-term agreement with Sage Hospitality Resources to manage the hotel property.

On September 15, 2004, the Company acquired the 299-room Omaha Marriott hotel for approximately $29.1 million. The Company entered into a long-term agreement with Crestline Hotels & Resorts, Inc. to manage the hotel property.

On September 17, 2004, the Company acquired the 202-room Courtyard Denver Airport hotel for approximately $18.1 million, which included the assumption of mortgage debt that encumbers the hotel property of approximately $11.3 million, net of discount. The Company assumed the existing long-term agreement with Marriott International, Inc. to manage the hotel property.

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

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

The results of operations for each of the hotel properties are included in the Company’s consolidated statements of operations from their respective acquisition dates. The following pro forma financial information presents the results of operations of the Company for the quarters and nine months ended September 30, 2004 and 2003 as if the 12 hotel acquisitions that occurred in 2004, as well as the five hotel property acquisitions that occurred in December 2003, had taken place on January 1, 2003. The pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which would have actually occurred had the transactions taken place on January 1, 2003, or of future results of operations. No pro forma adjustments have been made for the Hilton Tampa Westshore hotel or the Hilton Garden Inn BWI Airport hotel for the nine months ended September 30, 2004, as the acquisitions occurred near the beginning of the period (in thousands).

On June 30, 2004, the Company signed a definitive agreement with a hotel developer to purchase upon completion the 210-room Courtyard Gaithersburg Washingtonian Center hotel in Gaithersburg, Maryland. The purchase price for the hotel property is $29 million. The Company was required to deposit $8 million in an escrow account, which amount will be credited against the purchase price at closing or returned to the Company should the hotel developer fail to satisfy its obligations under the definitive agreement. Construction of the hotel is scheduled to be completed in the fourth quarter 2005.

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

4. Investment in Hotel Properties

Investment in hotel properties as of September 30, 2004 and December 31, 2003 consisted of the following (in thousands):

5. Asset Held For Sale

In connection with the acquisition of the Hyatt Regency Wind Watch Long Island hotel, the Company assumed a definitive agreement to sell a parcel of vacant land, which is adjacent to the hotel, for $3.0 million. The proceeds, less brokerage commissions and other transaction costs, from the sale will be split evenly between the Company and the seller of the Hyatt Regency Wind Watch Long Island hotel. As of September 30, 2004, included in other liabilities in the consolidated balance sheet was approximately $1.4 million, which is an estimate of the amount due to the seller.

6. Long-Term Debt

On January 8, 2004, in connection with the Hilton Tampa Westshore hotel acquisition, the Company assumed a $17 million mortgage loan that encumbers the hotel property. The loan bears a fixed annual interest rate of 7.9% and matures on July 1, 2005. Principal payments commenced in July 2004 and are based on a 25-year amortization period. The loan agreement contains a standard provision that requires the loan servicer to maintain escrow accounts over the term of the loan for hotel capital improvements and real estate taxes.

On July 9, 2004, the Company completed a $67 million financing, secured by the Hyatt Regency Savannah hotel, the Portsmouth Renaissance hotel and conference center, and the Hilton Garden Inn BWI Airport hotel. The loan bears a fixed annual interest rate of 6.47% and matures on July 11, 2011. For the period from August 2004 through July 2005, the loan agreement provides for monthly interest-only payments. Principal payments will commence in August 2005 and will be based on a 25-year amortization period. The loan agreement contains standard provisions that require the loan servicer to maintain escrow accounts over the term of the loan for certain items, including hotel capital improvements, ground rent, real estate taxes and insurance. In addition, the loan agreement contains a restrictive provision that requires the loan servicer to retain in escrow excess cash flow from the encumbered hotel properties if net cash flow, as defined, for the trailing twelve months declines below a specified level.

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

On August 19, 2004, in connection with the acquisition of the Hilton Parsippany hotel, the Crowne Plaza Atlanta-Ravinia hotel, the Hyatt Regency Wind Watch Long Island hotel, and the Tremont Boston hotel, the Company completed a $160 million financing, comprised of a $135 million mortgage loan and a $25 million mezzanine loan. The $135 million mortgage loan is secured by the four hotel properties. The $25 million mezzanine loan is secured by equity interests in the Company’s subsidiary that is the borrower under the $135 million mortgage loan. The financing bears interest at a fixed, annual, blended rate of 6.65% and matures on September 1, 2011. Principal payments commenced in September 2004 and are based on a 25-year amortization period. The loan agreements contain standard provisions that require the loan servicer to maintain escrow accounts over the terms of the loans for certain items, including hotel capital improvements, real estate taxes and insurance. In addition, the loan agreements contain a restrictive provision that requires the loan servicer to retain in escrow excess cash flow from the encumbered hotel properties if net cash flow, as defined, for the trailing twelve months declines below a specified level.

On September 9, 2004, the Company completed a $38 million financing, secured by the Dallas/Fort Worth Airport Marriott hotel. The loan bears a fixed annual interest rate of 5.8% and matures on October 1, 2011. Principal payments will commence in October 2004 and will be based on a 25-year amortization period. The loan agreement contains a standard provision that requires the loan servicer to maintain an escrow account over the term of the loan for real estate taxes.

On September 17, 2004, in connection with the Courtyard Denver Airport hotel acquisition, the Company assumed an $11.3 million, net of discount of $0.3 million, mortgage loan that encumbers the hotel property. The loan bears an interest rate of LIBOR, plus 1.75%, and matures on November 1, 2008. The loan agreement provides for monthly principal and interest payments, with principal payments being based on a 20-year amortization period. The Company also assumed an interest rate swap agreement that fixes the interest rate on the mortgage loan to an annual rate of 7.34%.

The following details the Company’s long-term debt as of September 30, 2004 (in thousands):

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

Future scheduled principal payments of debt obligations as of September 30, 2004 are as follows (in thousands):

7. Derivative Instrument

On September 17, 2004, in connection with the Courtyard Denver Airport hotel acquisition, the Company assumed an interest rate swap agreement that fixes the interest rate on a related assumed mortgage loan to an annual rate of 7.34%. The swap agreement terminates on November 1, 2008 and has an adjusting notional amount equal to the outstanding loan principal balance. The fair value of the interest rate swap of $0.9 million was recorded in other liabilities in the consolidated balance sheet. As the interest rate swap was not designated as a hedge, the change in fair value each period is recorded in interest expense in the consolidated statement of operations. As of September 30, 2004, the Company had no other derivative instruments.

8. Earnings Per Share

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

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

During the quarters ended March 31, 2004 and September 30, 2004, the Company issued 87,500 shares and 20,000 shares, respectively, of restricted common stock to certain employees, which did not require payments by the employees. Subject to continued employment with the Company, the restrictions on the employees’ shares lapse at the rate of one-third of the number of restricted shares per year commencing on the first anniversary of their issuance. The Company recorded unearned compensation of approximately $1.3 million and is amortizing the unearned compensation over the 36-month period commencing on the date of the issuance.

In connection with the IPO, the Company granted to its underwriters, as partial consideration for their 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.

9. Cash Distributions

On June 17, 2004, the Company’s board of directors declared a cash distribution to stockholders of the Company and partners of the Operating Partnership of record as of June 30, 2004. The cash distribution of $0.13 per common share and partnership unit was paid on July 15, 2004.

On September 14, 2004, the Company’s board of directors declared a cash distribution to stockholders of the Company and partners of the Operating Partnership of record as of September 30, 2004. The cash distribution of $0.09 per common share and partnership unit was paid on October 15, 2004.

10. Income Taxes

The components of income tax benefit for the nine months ended September 30, 2004 are as follows (in thousands):

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

As of September 30, 2004, the Company had a net deferred tax asset of $1.1 million, primarily due to tax net operating losses. These loss carryforwards will begin to expire in 2023 if not utilized by then. The Company believes that it is more likely than not that the net deferred tax asset will be realized and has determined that no valuation allowance is required.

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

11. Related-Party Transactions

As of September 30, 2004, 10 of the Company’s 17 hotels operated under management agreements with Crestline Hotels & Resorts, Inc., which is a wholly-owned subsidiary of Barceló Crestline, each for a 10-year term. Crestline Hotels & Resorts, Inc. receives a base management fee, and if the hotels meet and exceed certain thresholds, an incentive management fee. The base management fee for the hotels is generally between 2% and 3.5% of total gross revenues from the hotels. The incentive management fee, if any, for each hotel will be due annually in arrears within 105 days after the end of each fiscal year and will be equal to 15% of the amount by which operating profit for the fiscal year exceeds 11% of the Company’s capitalized investment in the hotel. Crestline Hotels & Resorts, Inc. will not be entitled to receive any incentive fee in any fiscal year in which the operating profit of the hotel has not equaled at least 11% of the Company’s investment in the hotel. The management agreement places a cap on the total amount of combined base and incentive management fees paid to Crestline Hotels & Resorts, Inc. at 4.5% of gross revenues for each fiscal year.

For the quarter and nine months ended September 30, 2004, the Company paid Crestline Hotels & Resorts, Inc. approximately $0.4 million and $1.1 million in management fees, respectively. For the quarter and nine months ended September 30, 2003, PHA paid Crestline Hotels & Resorts, Inc. approximately $0.1 million and $0.2 million in management fees, respectively.

Effective October 16, 2004, Marriott International, Inc. began managing the Tremont Boston hotel, which had been managed by Crestline Hotels & Resorts, Inc.

12. Commitments and Contingencies

Ground and Building Leases—PHA leases the Portsmouth Renaissance hotel and adjoining conference center from the Industrial Development Authority of the City of Portsmouth pursuant to two separate lease agreements, each for an initial term of 50 years ending May 2049, with four ten-year renewal options and one nine-year renewal option. Base rent under the hotel lease is $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 the Company sells or assigns the hotel lease to an unrelated party, an additional rent payment equal to 50% of the net sales proceeds in excess of the Company’s capital investment in the hotel and unpaid annual return of 15% on the investment will be due.

Annual rent under the conference center lease is equal to the lesser of $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.

The Company leases the conference center and parking facility adjoining the Sugar Land Marriott hotel from the Sugar Land Town Square Development Authority for a term of 99 years ending October 2102. The minimum rent is $1 per year, plus an incentive rent payment for the first 25 years of the term of the lease. If during any of those first 25 years, the Company’s cumulative internal

rate of return on investment in the hotel exceeds 15%, then the Company will pay incentive rent in an amount equal to 36% of the net cash flow and/or net sale proceeds for the applicable year in excess of the amount of net cash flow and/or net sales proceeds that would be necessary to generate a cumulative internal rate of return of 15%.

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

The Company leases a building adjacent to the Plaza San Antonio Marriott hotel from the City of San Antonio. The Company is in the second of four permitted ten-year renewal options, expiring in March 2008. Annual rent due under the lease agreement is approximately $0.07 million, adjusted annually for increases in the consumer price index (CPI).

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HIGHLAND HOSPITALITY CORPORATION AND PREDECESSOR

NOTES TO FINANCIAL STATEMENTS

(unaudited)

Management Agreements—The Company’s hotel properties operate under long-term agreements with five management companies, including Crestline Hotels & Resorts, Inc. (9 hotels; see Note 11), Marriott International, Inc. (3 hotels), Hyatt Corporation (2 hotels), McKibbon Hotel Management, Inc. (2 hotels), and Sage Hospitality Resources (1 hotel). Each management company receives a base management fee generally between 2% and 4% of hotel revenues. The management companies are also eligible to receive an incentive management fee, payable in monthly installments, if hotel profit, as defined in the management agreements, exceeds certain thresholds.

Franchise Agreements—13 of the Company’s 17 hotel properties operate under franchise licenses from national hotel companies. The Hyatt Regency Savannah hotel is managed by Hyatt Corporation and the Dallas/Fort Worth Airport Marriott hotel and the Courtyard Denver Airport hotel are managed by Marriott International, Inc. The management agreement for each hotel property allows the hotel property to operate under the respective brand. The Tremont Boston hotel is not affiliated with a national brand. The Company signed a definitive agreement in September 2004 that will allow the Tremont Boston hotel to operate under the Courtyard brand. Under the franchise agreements, the Company is required to 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.

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

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

13. Subsequent Event

On October 27, 2004, the Company announced the signing of a definitive agreement to acquire the 197-room Sheraton Annapolis hotel for $18.0 million. The entity selling the hotel is owned 33.3% by Barceló Corporación Empresarial, S.A., which is the parent company of Barceló Crestline, which sponsored the Company’s formation and IPO.

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

Overview

Highland Hospitality Corporation is a self-advised REIT that was incorporated in July 2003 to own upscale full-service, premium limited-service, and extended stay properties located in major convention, business, resort and airport markets in the United States and all-inclusive resort properties in certain beachfront destinations outside 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 967,211 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.

Since the IPO and the acquisition of the initial properties on December 19, 2003, we have acquired 14 hotel properties (two in December 2003 and 12 in 2004) for an aggregate purchase price of approximately $523.5 million, including the assumption of mortgage debt of approximately $28.3 million. We have accounted for the acquisition of the 14 hotel properties under the purchase method of accounting, recording these hotels at their acquisition costs. As of September 30, 2004, we owned the following 17 hotel properties:

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 approximately 98% by us and approximately 2% by other limited partners, leases its hotels to subsidiaries of HHC TRS Holding Corporation (collectively, “HHC TRS”), which is a wholly-owned subsidiary of the Operating Partnership. HHC TRS then engages hotel management companies to operate the hotels under management contracts. HHC TRS is treated as a taxable REIT subsidiary for federal income tax purposes.

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The discussion below relates to Highland Hospitality Corporation as of and for the quarter and nine months ended September 30, 2004. For the quarter and nine months ended September 30, 2003, the discussion below relates to Portsmouth Hotel Associates, LLC, which was one of the three entities we acquired on December 19, 2003 and was 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.

Key Operating Metrics

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

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

Executive Summary of Third Quarter Events

The third quarter 2004 was an active period for the Company. We closed on the purchase of nine hotel properties, consisting of 2,736 rooms or 55% of our current portfolio. We also raised $265 million of fixed-rate debt with a blended interest rate below 6.5%. Since our IPO less than 12 months ago, we have acquired 17 hotel properties, signed definitive agreements to acquire two more hotel properties, and issued or assumed approximately $293 million of long-term debt. Including planned renovations, we have now committed investments of approximately $670 million, of which 75% is invested in upscale, full-service hotel properties and 25% is invested in premium, limited-service hotel properties.

We continued to see a recovery in the lodging industry in the third quarter 2004 and believe that the lodging industry is in its early stages of a multi-year recovery. RevPAR industry wide increased 6.4% in the third quarter 2004 versus the third quarter 2003. As for our portfolio, we experienced a modest RevPAR increase of 3% for the same comparable quarters. We believe that a significant part of the reason for our portfolio’s lag in RevPAR increase versus the lodging industry increase is the result of our efforts to transition a majority of our 17 hotels through one or more renovation, rebranding, management company transition or stabilization processes. A summary of the hotels in our portfolio in transition is as follows:

We expect that this transition will affect our financial results over the next several quarters. However, once the transition is completed, we believe that we will be well positioned to take advantage of the continuing recovery in the lodging industry.

Results of Operations

Highland Hospitality Corporation—Three months ended September 30, 2004

Revenues—Total revenue for the three months ended September 30, 2004 was $36.0 million, which includes rooms revenue of $24.7 million, food and beverage revenue of $9.7 million, and other revenue of $1.6 million. Average occupancy, ADR, and RevPAR for the three months ended September 30, 2004 were 70.7%, $113.55, and $80.30, respectively. Revenues for the quarter ended September 30, 2004 included the results of operations of eight hotel properties for the full quarter and nine hotel properties for a

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partial quarter (see table above for hotel property acquisition dates). We expect to see a significant increase in revenues in future quarters as we benefit from the ownership of 17 hotel properties. For the three months ended September 30, 2004, revenues at our Savannah and Tampa hotel properties were negatively impacted by the unusual number of hurricanes that affected the southeast of the United States.

Included in the following table is a comparison of the key hotel operating statistics for our 15 hotel properties that were open and operating during the quarters ended September 30, 2004 and 2003. The Sugar Land Marriott hotel and the Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively, and thus have been excluded in the comparison. Results of operations for hotels acquired in the third quarter 2004 are included in the statistics for the quarter ended September 30, 2004 from their respective acquisition dates. Results of operations for the comparable 2003 period are included in the statistics for the quarter ended September 30, 2003. The hotel operating statistics for the 15 hotels for the quarter ended September 30, 2003 reflect the results of operations of the hotels under previous ownership.

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

Depreciation and amortization—Depreciation and amortization expense for the three months ended September 30, 2004 was $3.2 million.

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

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

Interest expense—Interest expense for the three months ended September 30, 2004 was $2.9 million.

Net income—Net income for the three months ended September 30, 2004 was $0.6 million, due to the items discussed above.

Highland Hospitality Corporation—Nine months ended September 30, 2004

Revenues—Total revenue for the nine months ended September 30, 2004 was $80.0 million, which includes rooms revenue of $53.3 million, food and beverage revenue of $23.5 million, and other revenue of $3.3 million. Average occupancy, ADR, and RevPAR for the nine months ended September 30, 2004 were 70.9%, $116.76, and $82.84, respectively. Revenues for the nine months ended September 30, 2004 included the results of operations of five hotel properties for the full nine months and 12 hotel properties for a portion of the nine months (see table above for hotel property acquisition dates).

Included in the following table is a comparison of the key hotel operating statistics for our 15 hotel properties that were open and operating during the nine months ended September 30, 2004 and 2003. The Sugar Land Marriott hotel and Hilton Garden Inn Virginia Beach hotel did not open for business until October 2003 and November 2003, respectively, and thus have been excluded in the comparison. Results of operations for hotels acquired in 2004 are included in the statistics for the nine months ended September 30, 2004 from their respective acquisition dates. Results of operations for the comparable 2003 period are included in the statistics for the nine months ended September 30, 2003. The hotel operating statistics for the 15 hotels for the nine months ended September 30, 2003 reflect the results of operations of the hotels under previous ownership.

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Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the nine months ended September 30, 2004 were $61.3 million. Direct hotel operating expenses included rooms expenses of $12.0 million, food and beverage expenses of $18.0 million, and other direct expenses of $2.0 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $29.3 million.

Depreciation and amortization—Depreciation and amortization expense for the nine months ended September 30, 2004 was $6.9 million.

Corporate general and administrative—Total corporate general and administrative expenses for the nine months ended September 30, 2004 were $6.8 million, which included non-cash stock-based compensation expense of $2.3 million. Also included in corporate general and administrative expenses were $0.3 million of nonrecurring start-up costs related to our formation, such as IT consulting and corporate governance costs.

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

Interest expense—Interest expense for the nine months ended September 30, 2004 was $3.5 million.

Income tax benefit—Income tax benefit for the nine months ended September 30, 2004 was $1.0 million. The income tax benefit resulted from a taxable operating loss incurred by our TRS for the nine months ended September 30, 2004. As of September 30, 2004, we had a net deferred tax asset of $1.1 million, primarily due to past and current year’s tax net operating losses. These loss carryforwards will begin to expire in 2023 if not utilized by then. We believe that it is more likely than not that the net deferred tax asset will be realized and have determined that no valuation allowance is required.

Net income—Net income for the nine months ended September 30, 2004 was $3.3 million, due to the items discussed above.

Portsmouth Hotel Associates, LLC—Three months ended September 30, 2003

Revenue—Total revenue for the three months ended September 30, 2003 was $2.6 million, which includes rooms revenue of $1.7 million and food and beverage revenue of $0.8 million. Average occupancy, ADR, and RevPAR for the three months ended September 30, 2003 were 68.5%, $110.01, and $75.36, respectively.

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the three months ended September 30, 2003 were $2.2 million. Direct hotel operating expenses included rooms expenses of $0.4 million and food and beverage expenses of $0.7 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $1.2 million.

Depreciation and amortization—Depreciation and amortization expense for the three months ended September 30, 2003 was $0.2 million.

Interest expense—Interest expense for the three months ended September 30, 2003 was $0.2 million.

Net loss—Net loss for the three months ended September 30, 2003 was $(0.1) million, due to the items discussed above.

Portsmouth Hotel Associates, LLC—Nine months ended September 30, 2003

Revenue—Total revenue for the nine months ended September 30, 2003 was $7.5 million, which includes rooms revenue of $4.6 million and food and beverage revenue of $2.8 million. Average occupancy, ADR, and RevPAR for the nine months ended September 30, 2003 were 66.9%, $99.98, and $66.93, respectively.

Hotel operating expenses—Hotel operating expenses, excluding depreciation and amortization, for the nine months ended September 30, 2003 were $6.5 million. Direct hotel operating expenses included rooms expenses of $1.0 million and food and beverage expenses of $2.2 million. Indirect hotel operating expenses, which includes management and franchise fees, real estate taxes, insurance, utilities, repairs and maintenance, advertising and sales, and general and administrative expenses, were $3.2 million.

Depreciation and amortization—Depreciation and amortization expense for the nine months ended September 30, 2003 was $0.5 million.

Interest expense—Interest expense for the nine months ended September 30, 2003 was $0.7 million.

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Net loss—Net loss for the nine months ended September 30, 2003 was $(0.2) million, due to the items discussed above.

Non-GAAP Financial Measures

Funds from operations—Funds from operations, or FFO, is defined as net income (loss), plus real estate related depreciation and amortization. Historical cost accounting for real estate assets implicitly assumes that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen or fallen with market conditions, most industry investors have considered presentations of operating results for real estate companies that use historical cost accounting to be insufficient by themselves. Accordingly, we believe that FFO is a useful financial performance measure for investors and management because it provides another indication of our performance prior to deduction of real estate related depreciation and amortization. The calculation of FFO may vary from entity to entity, and as such, the presentation of FFO by us may not be comparable to FFO reported by other REITs. The following is a reconciliation between net income (loss) and FFO (in thousands):

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

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.

Liquidity and Capital Resources

For the nine months ended September 30, 2004, net cash flows from operations were $15.4 million. For the nine months ended September 30, 2004, we used $416.7 million to acquire hotel properties and used $8 million as a deposit related to the signing of a definitive agreement to acquire the to-be-built Courtyard Gaithersburg Washingtonian Center hotel.

The hotel acquisitions discussed above were funded from IPO proceeds and long-term debt issued or assumed during the nine months ended September 30, 2004. During the third quarter 2004, we issued $265 million of long-term debt comprised of the following:

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During the third quarter 2004, we also assumed an $11.3 million, net of discount, mortgage loan in connection with of our acquisition of the Courtyard Denver Airport hotel. The loan matures in November 2008 and bears interest at LIBOR, plus 1.75%. The Company also assumed an interest rate swap agreement that fixes the interest rate on the mortgage loan to an annual rate of 7.34%.

We are currently in the process of establishing a term loan credit facility to provide additional capacity and flexibility for us to meet our stated investment objectives, while maintaining our targeted leverage objectives of approximately 50% debt-to-capitalization. We anticipate entering into this facility during the fourth quarter 2004.

As of September 30, 2004, we had cash and cash equivalents of approximately $30.7 million and restricted cash of $37.7 million. We intend to use our cash and cash equivalents and future borrowings under our credit facility after it is established to fund planned renovations at a number of our hotel properties, as well as fund the potential acquisition of the Sheraton Annapolis hotel, for which we signed a definitive acquisition agreement at the end of October 2004. Approximately, $27.5 million of the $37.7 million of restricted cash as of September 30, 2004 is required to be used specifically for renovations at four of our recently acquired hotel properties.

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 our credit facility after it is established. We believe that 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.

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 property improvement fund, which will be funded by a portion of hotel gross revenues. Routine repairs and maintenance will be administered by the management company. However, we have approval rights over capital expenditures. A number of hotel properties have begun or are beginning significant renovation projects, including the Hyatt Regency Savannah hotel, the Plaza San Antonio Marriott hotel, the Crowne Plaza Atlanta-Ravinia hotel, the Hyatt Regency Wind Watch Long Island hotel, the Tremont Boston hotel, and the Radisson Mount Laurel hotel. In the remainder of 2004 and first nine months of 2005, we plan to spend approximately $44 million on the renovations.

Contractual Obligations

The following table sets forth our contractual obligations as of September 30, 2004, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands). There were no other material off-balance sheet arrangements at September 30, 2004.

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Inflation

Operators of hotels, in general, possess the ability to adjust room rates daily to mitigate 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 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 contract values are based on the present value of the difference between contractual amounts to be paid pursuant to the contracts acquired and our estimate of the fair market contract rates for corresponding contracts measured over a period equal to the remaining non-cancelable term of the contract. Contracts acquired which are at market do not have significant value. An existing franchise agreement is typically terminated at the time of acquisition and a new franchise agreement is entered into based on then current market terms. Intangible assets are amortized using the straight-line method over the remaining non-cancelable term of the related agreements. In making estimates of fair values for purposes of allocating purchase price, we may utilize a number of sources that may be obtained in connection with the acquisition or financing of a property and other market data. Management also considers information obtained about each property as a result of its pre-acquisition due diligence in estimating the fair value of the tangible and intangible assets acquired.

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

Stock-based Compensation—We account for stock-based employee compensation using the fair value based method of accounting described in Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation, 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.

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 TRSs, we have not recorded a valuation allowance to reduce our net deferred tax asset as of September 30, 2004. 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.

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Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, and as such may involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe our future plans, strategies and expectations, are generally identified by our use of words, such as “intend,” “plan,” “may,” “should,” “will,” “project,” “estimate,” “anticipate,” “believe,” “expect,” “continue,” “potential,” “opportunity,” and similar expressions, whether in the negative or affirmative. All statements regarding our expected financial position, business and financing plans are forward-looking statements. Factors which could have a material adverse effect on our operations and future prospects include, but are not limited to: