Empire State Realty Trust, Inc. (ESRT) Earnings Call Transcript & Summary

Welcome to the 4:30 p.m. session at Citi's 2020 Global Property CEO Conference. I'm Manny Korchman, Citi Research. With me is Michael Bilerman as well, and we're pleased to have with us Empire State Realty Trust CEO, Tony Malkin. This session is for investing clients only and if media or other individuals are on the line, please disconnect now. Disclosure is available here and on the webcast. For those in the room or the webcast, you can sign on to liveqa.com, enter code citi2020. Tony, I'll turn it over to you to introduce your company and management team. And with that, please provide the audience 3 reasons why investors should buy your stock today and then we'll come back with Q&A.

Because we took the risk to come here at great physical danger. What I love -- I don't know if you guys noticed it, but every company is being given a -- CEOs are given a small personal container of hand sanitizer with lime and salt. So thank you for hosting us. I'm Tony Malkin, Chairman and CEO of ESRT, joined today by John Kessler, our President and COO; and Greg Faje, our VP of IR. Three reasons. Number one, our fortressed balance sheet with its low leverage availability under our line and significant liquidity was built to withstand crisis and to take care of opportunity that derives therefrom. We've got 5.1x net debt-to-EBITDA versus our peers at 7.6 at $14 a share, where we made a surprising move towards that number today. We are at 25% net debt to enterprise value, over $225 million in cash, $1.1 billion available under our credit line, which can be expanded to $1.485 billion. Number two, as our disclosure makes clear, the embedded derisked growth generated by redevelopment, both contracted for already and to come and internal growth of peer-leading new lease spreads, 24.4% on new Manhattan office leases in fourth quarter 2019, plus 6 consecutive quarters of net rent growth. $99 million in top line revenue, and of that, signed leases and free rent from leases -- signed leases not commenced and leases commenced in the free-rent period, $52 million of that is already contracted. So we've got a benefit there. And then finally, we have, in our great well-relocated portfolio, really nearly completed our redo, really nearly completed our rework of all of our assets. So we look forward to grinding the stuff down to the bottom line. And with that, all yours.

Great, Tony. So we've been starting each of these sessions asking every company about ESG, which I know is near and dear to your heart, given the stuff that you do for the roundtable as well as the company and in the Empire State Building. But what is the one thing that you're focused on to improve ESRT's overall ESG score over the next 12 months?

I think we are AAA in what we do. We're a D minus in what we communicate. So we brought in someone who's worked with us for over 12 years to be our new Senior Vice President of Energy and Sustainability. Her name is Dana Schneider. She previously was Managing Director at Jones Lang LaSalle for their north -- running their North American practice and sustainability. We also have someone in our General Counsel's office who we like quite a lot, who we wanted to put on the General Counsel track. She was not interested in that, but she was interested in getting involved in other ways. So she is our new Director, Senior Vice President, Director of ESG, along with her ongoing role in Leasing. And so I think that the goal here for us is to take our portfolio, for which we will pay no fines in 2024 at all as in the first level of Local Law 97, and through which we're going to go -- with which we're going to go through version 2.0 of our energy efficiency retrofit work, try to bring that number down even more. So we work along with the grid towards a goal of 0 fines in 2030. And to continue to utilize my role and communicate my role as, for instance, I'm the only industry representative on the Mayor's Advisory Board for the implementation of Local Law 97. We work very closely with the New York State and New York State Energy Research Development Authority, and I'm the Chair of the Sustainability Policy Advisory Committee of the Real Estate Roundtable, communicate better what we do while continuing to do an excellent job and to really be industry leading.

So one of your things in the top 3 reasons, you talked about the liquidity and the balance sheet that you have. One of the constant discussion points has been using that capacity to buy back your stock. And I think that there's always been this ongoing that there is a price to which you would want to be active. The market volatility certainly has provided -- your stock's never been at this level before, right? So even though it's up today, its absolute level has never been there. So can you talk a little bit about how you're approaching, using any capacity, knowing that you have the authorization? You've had the authorization forever. And so can you sort of frame it for us today where things stand, given where the shares trade?

Right. So I'm going give you a painful response that's well considered, which is that we're not going to comment on the stock buyback at all. And we've told that to folks in our one-on-ones, two-on-ones, three-on-ones, and that is advisedly so. So I will say that we are very conscious in general of our balance sheet. And as we come through the completion of the work that we are doing, we look to deliver to the bottom line the top line growth that we are creating. We need to look at that balance sheet, which is not designed just to sit there like that. So it's -- we definitely have a focus on utilization of the balance sheet, but we're not going to comment on the buyback.

What other sources or uses do you see for that capacity? So how would you rank and what are those opportunities to put capital to work, absent a stock buyback?

So I think we've been very effective in executing on a strategy for which we had a lot of doubt in this room through -- over a bunch of years, not necessarily from your side of the table but from investors as to whether or not we would be able to execute and generate the positive outcomes. Empire State Building is over 96% leased now. As we go through our portfolio, we've got 4 years where we've leased more than 1 million square feet, 1.3 million this past year. We have just leased to better and better tenants with better credit at higher and higher rents and longer lease terms. We have no exposure to Convene, WeWork, any of the shared office space or enterprise space providers. So we take a look at -- well, a Yogi Berra-ism that I've used here before, we come to a fork in the road, we'll take it. I think it's time for us to recognize that with this amount of liquidity and with this cash and with this availability on our line, it's time to put it to work. We do look at our opportunities to acquire in the market. We are spending -- we have spent more time on that. We have underwritten more deals. We have not gotten to the point yet where we find anything compelling. And I think that when we get to a point of really, everything is flowing through with the redevelopment of the Observatory, 9% top line growth in the fourth quarter, 13.1% NOI growth from the Observatory in the fourth quarter. Said it before, I'll say it again. We don't give interim updates, but we're quite pleased with how things are going and our competitive position. We're quite pleased with the performance through the first quarter. It really does come down to what is our true cost of capital and what are the assets which are worth overpaying for, which is the way I would look at what's going on in the market today. None of them is for sale right now based on our analysis. And we absolutely do look at the subject which we're not going to discuss. So I don't think it would be wrong to think that we're not going to move. We do look at our asset type and our skill set, which is to redevelop assets, which generally are thought of as be in good locations. WeWork is in the process of -- has begun a process to approach its landlords and, as they call it, modify their contractual arrangements. And we think that there are opportunities that may kick out of that. However, we're going to confront ourselves the opportunities at hand, and we're going to make our decisions based upon what we think are the best ones with the knowledge that it's time to utilize the balance sheet.

So if we're not going to talk about he who shall not be named, what -- is there anything restricting you? Because obviously, you're not in earnings anymore, so you don't have a blackout.

Correct.

Would there be anything precluding you from acting on a buyback?

No.

Okay.

So Tony, earlier, on the ESG question, you graded yourself AAA on what we do and a D minus on what we communicate?

As part of ESG.

On ESG, correct.

Yes, I just want to be clear.

Can you give...

Well, I mean there are lots of [indiscernible] AAA and we're never going to show it.

Now we're going to go head to toe. So where do you think you are on other investor communications? So that's sort of communication on your ESG strategy. Where do you feel you are in other investor communication on that same report card?

Now I think we've actually enhanced our disclosure right up to the point of -- in many ways, I think people will look at it and say, "Will you provide?" And they do this, say "Will you provide guidance on this, that and the other thing? Why don't you provide guidance on everything?" And as you may know in this room, in last year, we were accompanied here to this meeting by David Karp, who retired in the summer of 2019. And we don't have a new CFO yet. In fact, what we chose to do is to let our Chief Accounting Officer and our Head of Financial Planning and Analysis have the opportunity to grow in their roles. And a lot of work which is getting done today, which has been done by others, being done by them. John Kessler, our COO, has been careful and attentive to those processes to make sure that nothing gets slipped and helped in the communication. Greg Faje, our Head of IR, is someone who is just a couple of years into the spot and taking -- anyone who's listened to our calls know that Greg handles all the calls with regard to what would historically be handled by the CFO. Our audits have been unblemished and the folks have really risen to the opportunity. So we look now at the CFO, in partial response to Michael's earlier question, and we say, we're not looking to hire someone who did David's job. We're looking for someone who's going to be much more market facing and if possible, more investment facing. And we look at that as an opportunity to build off of what we already do well, and at that point, have a discussion with the new CFO about whether or not we're at a point of looking at guidance. So it's definitely something which is out there, and we definitely look at it as something that we'd like to approach with a new CFO. And we believe that as far as our supplemental is concerned and as far as our investor presentation, we're doing a -- not just a much better job but a very good job, and we're just short, frankly, of just "guidance."

Yes, I would just add on that in particular, on the supplemental and all the detail we give there, we've been told by a lot of investors, some in this room, that they're appreciative of the level of detail and clarity and specificity that we provide.

Right. And I think that, that drives the question of why not give the guidance? Were you giving enough of the pieces? They don't give the whole, and then when the whole doesn't line up with the pieces, people say, "Well, had you only given me that extra piece, we would have gotten there." So I think...

I think you're spot on there.

The fact that you're so far along with everything else is what drives the question more so than if you just gave us a sheet of paper with 5 numbers on it, people would say, "These guys don't give us anything. Why would we expect more?"

Right. And I think you're spot on. That's a discussion which is well underway. And again, I think it behooves us to choose a CFO and to move on something like that logically and make that decision in that time frame, certainly is something that we've discussed as -- look, people talk about running tabletop exercises. Our own modeling is very consistent with our outcomes. So we've gone through it. And I think that a lot of the variation, which one might expect from a massive re-tenanting, redevelopment of a portfolio, a lot of that uncertainty is out of the picture.

So on your call, we started a conversation on the coronavirus' impact on certain New York City tourism and especially the observation deck in China. Looking at the attendance of this conference and others, obviously, people are more worried about it state-side than they were a couple of weeks ago when we last spoke.

I don't even feel that good right now. I think I have a slight fever.

You should not go to the observation deck. So I know you don't like giving intraquarter updates, but could you give us an update as to what you're seeing? And have you seen any contraction in whether it be global tourism, U.S. tourism, everything? Or make us feel better that nothing is happening.

So we feel good about what we're seeing in the first 2 months of this year. We just closed February. We had -- look, we've had worse weather and we're very happy with what we have done. The -- December, we had 10 weeks of 102 open. We had about 2.5 weeks of 80, which is the balance of the observatory redo done. I don't know if a show of hands of people who have been there. You would not be able to fathom what that experience is like. We have -- so that's to date. Bottom line, if there are travel interruptions, they will hit our observatory attendance. It may well be that people are not going on cruises, that people are not traveling to Asia. And therefore, there is more intra-U.S. travel and maybe we are benefiting from that already, who knows? We had already made the move away from the MICE, the incentives and conventions and large tours out of China. They were demanding discounts, which we simply wouldn't give and we're really about 18 to 20 months into an exclusive focus on FIT, the independent traveler out of China. That's worked very well for us, it's a much higher-margin business. And I can just say anecdotally, that business has not gone away although there are fewer flights into New York, I think, 6 weekly flights into New York now. That also said, China does appear -- not appear. The facts say China is opening up. Suzhou, the resort town of Suzhou, is reopening. Shanghai Disney is contemplating and open soon. So as this thing ripples around, I think you'll see more travel coming from there. Anybody see the Saturday Night Live skit on LaGuardia this past Saturday night? It's well worth bringing it down on YouTube because there's an element about travel and LaGuardia on that, that's particularly funny. That said, going back to your question and your comment, Manny, there's no question that we could see an interruption, that said, that won't change the reality that the new Hudson Yard Observatory has an elevator experience just like the one at One World Trade. They have a restaurant experience, which is nicer than the one at One World Trade. It's a David Rockwell experience. Outside of that, it's pretty sterile Port Authority-ish setup is what they have to offer. And we anticipate that One Vande will also have a similar sort of modern thing. So I think that they're all competing for the same tourists who wants to come look at the Empire State Building. They don't offer a lot other than that. And so from that perspective, we think there'll be a lot of noise in 2020, and we think we'll come through with a -- even without COVID-19, there'd be a lot of noise. And we think we come through it and we're still the best show in town by orders of magnitude.

Questions in the room? So during or -- with earnings, I guess, you announced a new lease at Union Square with Target that doesn't commence until 2024?

2023.

For GAAP purposes, 2024, right?

So they don't open until 2024. No customers until 2024?

It's possible -- under its current contract, yes, it's possible the existing tenant may want to leave sooner, in which case it would start sooner.

So were you surprised that a store like that would be looking for locations so far in advance, especially given this retail environment in New York today?

No. We -- look, I think there are very few good tenants in New York City for retail. And some of those, T.J. Maxx, Target, they know what they want, they know where it is, and they're planning a long time in the future. We have a Target store, which from our understanding, is the #1 sales per square foot urban Target store in their entire network at 112 West 34th Street. This is the retail side of our headquarters at 111 West 33rd. And we've been in discussion with them on Union Square for -- since the moment we signed that lease. So no, we're very happy. We see a lot of unsettled conditions in retail still going forward. We're happy to have doubled the rent with this lease. And if we had the choice to do it again, we'd have done the exact same thing. Buttoned up long-term lease, great credit, move on.

Maybe a quick update on the suburbs and what's going on there, just those trends were not great in the quarter. Do you expect that to continue?

Sure. I think we've seen the bulk of the move-outs that we're going to see. Our biggest move-out from the suburbs, which is something which was not a downsize but a move-out, was a 75,000-square-foot tenant, which has occupied that space for more than 2.5 decades, and they've moved to a beautiful brand-new space that they subleased from GE, and there was just -- yes, nothing to it. That space needs to be scraped and cleaned and leased. Most of our other move-outs, bar 1 or 2, have been actually in-place renewals and downsizings of tenants. And the good news is we've got good movement but we've made our folks signing leases with us. The rents are not, in all cases, as high as our expiring fully escalated rents. That is more than made up for by our market-leading cash rent spreads in New York City. And it's good to see that the work that we have done with the CapEx and upgrading of our lobbies in our common areas and the buildings, which have the leasing to do, has worked well. So am I happy with the fact that the leases are at a lower rent than expiring? No. Am I happy that we're renewing a lot of those tenants at a smaller footprint? Absolutely, and happy with the renting that we are doing. It's good to have the tenants.

So Tony, in terms of -- obviously, the stock price performance is not where you or shareholders want it to be.

No.

Do you attribute -- I mean, if you think about the impacts, you clearly have the view of competition at observatory decks. You have sort of management transition of some sort of not backfilling the CFO. You have lack of external investment other than investing in the Observatory, but no buybacks, no acquisitions, which is a big part of the story when you went public was a lot of the relationships that you talked about and -- but partially difficulty to unlock those, but nothing external, other than the option assets you had. It's a G&A load relative to the size of the company. I guess, which one do you think or how would you weight them? Maybe it's lack of FFO guidance and clarity, I don't know, like -- how do you look at those variables to say which ones are having the biggest impact on the stock? And what -- how do you address them, right? Or do you think they're not valid, and therefore, the stock should be a lot higher?

I think everything is -- that you mentioned is valid. I think that when -- the bottom line is people did not understand how long it would take and how much it would cost, even though we laid it out in order to vacate the floors and retenant the floors and for rent to commence. And we went through an experience where in the first quarter of 2018, we had to reeducate everyone as to their models and really talk everybody down. And I think that in this world, people pay -- in the REIT world, people pay for results not what's on to come, particularly when there are a lot of choices out there, and there's a diminishing amount of REIT-dedicated managers with -- or certainly a diminishing amount of money under management by them. So I'd take a step further, and I think that we've got some -- we got ways to explain every one of the items that is out there. That said, I think it's better to note that we have plans to execute on each one of the items that you referenced. I absolutely do believe that the G&A piece has a couple of unique factors to it, particular, the aging of our NEO group and the 60-year-old eligibility for retirement, which causes vesting for accounting reporting purposes, to have to be accelerated as opposed to the actual vesting, which continues over 3 years. We had executives who put off -- who deferred cash bonuses in exchange for LTIPs and then those LTIPs go into a vesting mode. And so all of these things are coming together in a perfect storm. We added a new CTO, Chief Technology Officer, really to change the way we do our work, everything from repetitive process automation tool, the fact that we have rolled out Salesforce now in our Observatory, our leasing and our digital and social outreach for our brand and our online commerce for the Observatory. So when we put all of these different pieces together, there's no silver bullet. It's buck shot that's all hitting. I will say that the G&A, excuse me, will bell curve. It will grow then shrink as it normalizes with the change in accounting for the benefits of the elderly comp as we move towards age 60 for Tom Durels, for me, and then ultimately, I think, everybody else who approaches 60. That said, I think the Observatory comes together or it has already come together, as I noted. I think that the office top line growth flows to the bottom line. I think that our G&A gets smaller because of that. I think we get done with -- so I think there's been a comment made probably overly emphasized, the relationship piece. It's still out there. There's a deal with which -- there's a family with whom we've been chatting for a very long time, where -- in the most recent meeting, it was botched because they gave them the wrong Parkinson's meds. They gave them his nighttime pills. He fell asleep during the meeting. It was supposed to be an important meeting. Instead, they put him to bed. So there's a -- these are slow things to come to fruition. I think we definitely have an inside track relative to anybody else. I think the more important thing is that the #1 thing we came out with when we went public was that we are going to redevelop our portfolio, that we're going to get rid of thousands of tenants and in their place, bring in hundreds of tenants that we're going to get better credit quality, longer leases and much higher rents. And that's really what we've accomplished and it needs to come to play in our numbers. It needs to come into our bottom line. And then we need to utilize our balance sheet, which, to be fair, we did harbor a very strong balance sheet in case things didn't work along the way. There was a period of time where if we had COVID-19 3 years ago, that could have had a very awkward impact on our bottom line while we're in the middle of doing a heck of a lot of work in our portfolio on vacating space and moving people out and doing that redevelopment and re-leasing. So if you look at our supplemental, see our CapEx spend is coming down. If you look at our contracted new leases and the rate of leasing that we're doing and the prices at which we're doing the leasing, that's positive. And I do think that we need to focus on the utilization of the balance sheet. So I think there's an opportunity for all those things to come together nicely. And I think we're in an environment where, candidly, it's an E, all of the above, can't really separate one out from any other as far as how we've performed. We've been the underperformer for the last 52 weeks, period. Not happy about it. We have been. We need to do better.

So somebody on the live Q&A put in this question from an earlier meeting. I'm going to reuse it for you because I think it's relevant. So whoever gave it to us, thank you twice. How concerned are you about degradation of the New York City business environment? Antibusiness climate, for example, Amazon snafu, increased crime rates, rent control potentially cutting off affordable housing supply, tax issues, property tax, et cetera?

So again, if you watched Saturday Night Live on Saturday night, you'd hear a song about de Blasio on there. But that said, New York City is a great place to do business. Don't take it from me, take it from the fact that Facebook, Amazon, Apple and Google have all taken on commitments, in the aggregate, millions of square feet for jobs they do not presently have in New York City. There are tens of thousands of housing units which have been delivered in New York City. I won't say that they're all going to work out for the people who've developed them, but they provide housing en masse for new workers to come into that marketplace, which are not available in Seattle, they're not available in the Bay Area. So when we look at the smartest businesses, yes, some of it's going to Northern Virginia. Yes, some of it is going to Pittsburgh or Austin, but the highest-paying jobs are coming to New York City. So from that perspective, you could say, "Well, gee, if business goes wrong, there's going to be a lot of space left to sublet." In my view, that's a lot of jobs that will be coming into New York City, a lot of housing which is already built, which we'll be able to accommodate them, even if they don't necessarily get sold or rented at the prices which people thought they would get originally. And beyond that, we need to be involved as an industry in a more constructive way with the next administration that comes through. The real estate industry has been a whipping post for the current administration. And I think that -- look, I'm encouraged to think that Ray McGuire, your Co-Head of Investment Banking and Vice Chair, may be running for Mayor. That's now been reported twice. We need a responsible adult in the room and we need to deal with the fact that in general, New York City is an absolute anchor to the economic viability and growth of this country. It's the only -- I've said it before in this room, it's the only global capital which is neither a capital of a state nor a nation. And I think it remains very competitive. I would have been a lot more moribund in my thinking 18, 24 months ago. I look at the commitment of new jobs to New York City, good high-paying jobs in New York City and I'm very encouraged.

Questions in the room?

Quiet audience.

Tony, what are the benefits of being public today?

Gosh, a unified balance sheet. If you look at the reasons why we went public, we have a unified balance sheet. We have modern governance structure. We are able to raise debt very effectively. We sold 622 million shares at $21 a share. And I'm still alive. I was over in Doha just the weekend before this last one. So there, they haven't lost heart completely at this point, our Qatari partners. So I think that there's a...

They let you out of the country to come back?

Those are real.

Do you have slashes on your back?

I have no slashes on my back, but I do have some new calories from sheep and goat.

That was your comment?

The fact is that there are a lot of benefits to be public. Everything is cyclical, right? So who knows if...

You forgot to say that you get to be here with us. You missed the opportunity.

That was going to be the closer. And the fact is we get to express ourselves to investors who get to make decisions every day. I said that when our stock was at $21, I say it when our stock's at $12, truly. So I think that is an undeniable benefit and it gives us a lot of flexibility. I think that -- look, the other people out there who, I think, are tired of being public, I was tired of being private. So I think this is a better result for us.

You talked about the governance side. I mean, the suburban assets, which clearly are not performing and don't fit well with the New York-centric portfolio, have tax protection, right? So yes, from a governance perspective, you've brought the company into a modern world, but there's still some relics of private company and ownership.

That's right. And my parents are still alive.

I don't want to get into that. That's not...

It will eventually burn off.

I don't want to give them the same medicine like the other guy.

Yes. Well, A, it will eventually burn off; and B, look, we are not in the mode of selling our stock and selling our assets, excuse me, and recycling our capital to buy in our shares en masse the way some folks have. There's no way we're going to sell assets in the suburbs and able to -- which produce, even though now they're consuming some capital, they were providing a lot of capital very nicely. So there's just no way to replicate those returns to invest in New York City today. So it's to sell those and pay tax or to sell those and do a 1031. We've got plenty of cash to expand.

But how do you -- you brought up the comment of not selling it to buy back the stock and then saying you don't have the opportunities in New York. The other company you're referring to says the same thing. And they said that's why they're buying back the stock. So what's the opportunity in the stock versus buying an asset in New York? That's the way they're thinking about it. How do you think about that?

Well, I believe that whatever company that might be, maybe they're not happy being public. And so I just look at it from that perspective. And quite frankly, they have a balance sheet which really requires them to maintain a stock price. We don't.

All right, 3 rapid fire in this. Will the office sector have more or less fewer public companies a year from now?

Absent a material disruption driven by COVID-19, the same.

Same is not the answer. Do you think it's going to tilt fewer or...

This session has ended. The next session will begin in 5 minutes.

Run-DMC.

If I had to pick a fulcrum, I'd say fewer.

Okay. Same-store NOI for the office sector in 2021, this year is?

Aside from VNO, understandably from its redevelopment, there's going to be an interruption for the rest of us. We expect to see the NOI growth to be comparable to last year, about 3%.

Tenure is at 106 now. Next year?

I think it will be higher, 150 to 175.

What year will the U.S. enter a recession?

I don't think New York enters a recession for quite some time to come. There's been a lot of growth, a lot of new jobs and...

Sorry.

And we're ready for Steven Tyler. Thanks, everybody.