Survival Mode

Tarragon Corp.'s sale of about 8,000 units across dozens of properties, including this one in Savannah, Ga., helped give the firm a healthy dose of capital liquidity.

Credit: Lanny Nagler Photography

Going into the summer of 2007, Tarragon Corp. CEO William S. Friedman says he had a plan for the New York City-based firm. Friedman wanted to split the company into two parts. One would be a real estate investment firm that would hold multifamily and commercial properties, while the other would focus on development. Then, the credit markets crashed. “The increasing need for liquidity and the continued decline in the home sale market frustrated our plan,” Friedman says. “We had to go to a plan B.”

Plan B entailed radically reforming the balance sheet, which concentrated on the development business, and finding a partner to grow the investment portfolio. The company followed that template, but, in the process, became much smaller. Tarragon was lucky to come into a much needed jolt of capital, but the firm's experience is a template other cash-strapped for-sale builders could follow in the future.

Tarragon did not learn its lesson after its first foray into the multifamily sector. The firm's operations are rooted in the apartment business, but the 25-year-old company dabbled in condo conversions with success in the 1970s and 1980s. Then, about 10 years ago, it became active in condos again, investing in land and buildings throughout Florida. For a while, things went great, but then the market turned in 2005 and 2006, leaving the company trapped under a lot of conversions.

“In Florida, they were overextended because they bought all of these rental apartments to convert to condos,” says Cushman & Wakefield's vice chairman Andrew Merin, who orchestrated Tarragon deals in Florida and New Jersey.

Tarragon also got stuck in bad debt situations. It underwrote many deals at condo cap rates and was then forced to operate them as rentals.

“Once the debt markets turned, they needed a considerable amount of refinancing that they couldn't do,” says Haendel E. St. Juste, an analyst with Green Street, a Newport Beach, Calif.-based REIT research and consulting firm.

Friedman started hawking off his conversions in 2006, using three criteria to determine which properties he would sell. First, he disposed of properties Tarragon couldn't afford to own—the ones that had lots of locked-up equity. Second, he sold assets that required significant investment or a long holding period before they could generate cash. Finally, he got rid of properties that no longer fit in the Tarragon portfolio—those properties acquired for conversion and now stalled. So, the company leased them up and sold them.

Since 2006, Tarragon has sold 6,771 units for more than $700 million. The sell-off was only part of the reclamation effort, though. Tarragon also needed help from its lenders. In March, the company announced that it had reached agreements with the holders of $125 million of corporate-level unsecured subordinated notes. The agreement, effective through Sept. 30, gives the company 270 days to decide whether to purchase its notes at a discount. Its covenants are waived until this deadline occurs. “It gives us a choice of taking 18 months to recast our balance sheet and meet the covenants in that loan agreement or pay them off at a discount,” Friedman says. “Even though paying it off at a discount is very attractive in terms of repaying our capital, you have to recognize that that kind of debt is an attractive thing to have on your balance sheet. The debt has never been accelerated.”

To radically change its balance sheet, Tarragon needed to do more than chop off some assets. It needed capital. After negotiating with a number of suitors, in late March, the firm announced a $2 billion joint venture with Newton, Mass.-based Northland Investment Corp. that would entail giving up about 8,000 units. The deal doubles Northland's multifamily portfolio, adding 7,433 multifamily units in Florida, where Northland is making a contrarian play, and New England, which has high barriers to entry. These new additions satisfy two of Northland's three core target markets (the other is tech markets).

“There was good overlap with our portfolio,” says Lawrence R. Gottesdiener, Northland's chairman. “It gave us growth in two core business areas, good scale, and access to capital and opportunities.”

Northland will hold a 77.5 percent controlling interest in the joint venture, called Northland Properties, and Tarragon will hold a 22.5 percent interest. The joint venture also creates a new management firm, Northland Properties Management, that will provide property, asset, and construction management services to the portfolio. “We believe that together we will do better,” Gottesdiener says. “We will lower our cost of insurance, lower the cost of training, work through best practices, and have the scale to get a good Web-based computer system. There was a strategic fit between the two companies that will make us each stronger.”

As part of the deal, Northland is providing capital-starved Tarragon with a $50 million loan commitment. If drawn down by Tarragon, the loan would be a senior secured two-year loan. The proceeds of the loan, in conjunction with additional cash provided by Tarragon, would be used to purchase a portion of Tarragon's subordinated debt at a discount. Tarragon's minority interest in the joint venture will secure the loan. “The joint venture helps a lot,” St. Juste says. “It reduces a good chunk of the debt on their balance sheet.”

As part of the joint venture, Northland will put the properties purchased from Tarragon back in the joint venture. “In effect, we're acquiring an interest in the properties that we sold,” Friedman says. “Instead of owning the properties, we're getting an interest in the joint venture, which owns $300 million of properties and about $750 million of properties that Northland is contributing. We're generating a significant amount of cash from the asset sales and having a lot of our debt paid back.”

After the Northland joint venture was completed, Tarragon had divested itself of about three-fourths of its portfolio. “We completed a radical transformation of our balance sheet with a continued opportunity to work with our management company, which is merging with Northland's management company,” Friedman says.

That leaves Tarragon's balance sheet looking dramatically different than it did a year ago. “We will be smaller, better capitalized, and have much lower-leveraged debt based on the transactions that we've already embarked on,” Friedman says.

But there are still issues. The company incurred a net loss of $388.4 million during the year ending Dec. 31, 2007, and as of that date, total liabilities exceeded total assets by $93.6 million. That being said, the company's interest expense fell significantly in the first quarter of 2008, despite holding on to debt figures that still seem high. What's more, the company was in danger of losing its NASDAQ listing because it didn't hold its annual meeting by Dec. 31, 2007. In early May, the firm found out that NASDAQ would continue listing its stock when it had its annual meeting on May 1, 2008.

The Tarragon tale points to a trend in finding alternative strategies for navigating the tough financial markets—especially when it comes to fractured condo deals. For companies that got tied up too heavily in condo conversions, leveraging their income-producing apartments may be a viable lifeline. But that also means that they'll need financial partners to make things work. In fact, St. Juste says Tarragon may need to do a public offering or add a financial partner: “At some point, they'll likely need an equity infusion.”

ACTION ITEMS

IMPROVE THE ODDS

Trapped under a lot of assets? Here are three ways to ease the pain.

• Manage lender relations. Lenders don't want to take over large portions of real estate, and they'll continue to work with developers that they can trust. To build that trust, it's important to stay in contact with your lenders.

• Sell, sell, sell. Whether you decide to turn condos into apartments and sell them—or just auction them off—it's important to generate capital any way you can.

• Take control of debt. Look for partners who can help you pay down or buy back your debt. Or, take the money you earned from sales and pay down your debt.