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

Good afternoon, everyone, and welcome to Citi's 2021 Global -- Virtual Global Property CEO Conference. I'm Manny Korchman with Citi Research. We're pleased to have with us Empire State Realty Trust and CEO, Tony Malkin. This session is for Citi clients only, if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. For those joining us today, if you'd like to contribute questions to the conversation, throw them in the box on your screen, they'll come to me. I will try to weave them in. Apologies if I don't see them. Tony, I'll turn it over to you to introduce the company, any members of management that you'd like to intro, and then we'll get going with Q&A.

Terrific. Thanks so much for hosting us. Tony Malkin, Chairman, President and CEO of ESRT. Joined today by Christina Chiu, our EVP and CFO; Greg Faje, our VP of IR is off camera and muted off to the side. Three reasons why investors should invest in ESRT are: number one, our capitalization, strong and flexible balance sheet, 37% net debt to enterprise value, $1.6 billion of liquidity, 1/3 of that is in cash. We have no maturity on debt until November 2024. We have a great runway. We prepared for this environment. We can buy back our shares and pursue external growth, and we have all the funds we need in order to operate on our -- execute on our strategy. Two, $35 million in contracted revenue growth, strong operating leverage from our Observatory business to take advantage of growth opportunities. Revenue growth, $14 million from free rent burn off, $21 million from signed leases not commenced. On the Observatory restart, visits continue to go off a very low base. That said, we've never had an opportunity to start from 0 before. So while we were shut down due to COVID lockdown, we really reformatted our business. We believe we have permanently reduced our expense. We will have to increase our expenses from where we are now as we go forward, but the operating leverage off of increased traffic through the Observatory is huge. Our per caps have never been higher. Our feedback is terrific. We now have time ticketing, which allows us to modulate who gets in when. So with the preference towards our retail investors. And we really -- we're very pleased with the fact that we've got a completely rebuilt Observatory, which will benefit from restart. And the last piece of that second reason to invest is the external growth opportunity. We began our hiring process in November of 2019 to bring on an investment staff. By the second quarter of 2020, we brought on Aaron Ratner, who joined us from TPG. By the fourth quarter of 2020, we're fully staffed. Our number 2 is from RXR. And then our 3 and 4 are -- they're good folks, but you wouldn't know where they're from. And the bottom line is that while other people are cutting back on their investment staffing teams, we have the balance sheet, which allows us to build one. And the last piece is why you should buy ESRT is -- the future of real estate is the differentiation between those who have and do not have good ESG. The future in our modernized portfolio is where we are today. We are leaders with energy efficiency and indoor environmental quality, 100% of our portfolio is now powered by renewable wind energy. We are a leader in indoor environmental quality through the use of MERV 13 filters bipolar ionization and increased ventilation, allowed people to return to the office with confidence. We are the only commercial portfolio in the Americas, North, Central or South, to achieve the WELL Health-Safety Rating. There's one other readout there who has one lab, which has been WELL Health-Safety Rated. So WELL Health-Safety is much tougher to get than the Fitwel, which a lot of folks have used. It's the standard in Europe. It will be the standard, we believe, in the United States. We have it in our first year of filing under GRESB. We got a 5-star rating, Green Star recognition. Our score of 88 places us in the top 20% of respondents. We had an A for disclosure, we're a Fitwel Champion. What does all this mean? With our incredibly competitive price offer, we believe we will attract the tenants who has the return to business and focus on ESG into our environmental quality. We'll increase their focus on 2 strong landlords that can help them fulfill their own company mandates for healthy buildings, energy efficiency and ESG. So with that in mind, I hand it off to you, Manny, and go from there.

Might as well off of that strong ESG commentary fulfill the rest of our -- or one other question we had here, which is what are 3 priorities you have in place to improve that score even more this following year?

Sure. We've brought good leaders, and we have not made it easy for people to see our leadership. We are AAA in what we do and probably D minus in our disclosure. We made big strides in 2020, and we will maintain those strides and build upon what we have done in 2021. For example, we'll do our first ever sustainability statement presentation. It will be out end of March, beginning of April. We will enhance our disclosures and continue our policy leadership position. So through the proxy and through our sustainability report, we'll make our disclosures much easier for the people who call for the information to rate us to find the information. We've already been upgraded by one of the raters as we get out our new proxy and our sustainability report, I think, will increase that very easily. We are in the room where it happens, and we make it happen. So I serve as the Chair of the Real Estate Roundtable Sustainability Policy Advisory Committee. So on a national level, very active. Our partnerships with New York State are very active. I am the sole New York City real estate industry representative of [ the mayor's ] Climate Mobilization Advisory Board to implement Local Law 97. So we look at this to help shape policy and legislation. And we move this forward. And I think you should look for us to discuss more on our energy efficiency leadership in the months to come as we have no fine to pay in 2024, but we have steps which we have underway to maintain and demonstrate our efforts to achieve the 2030 standards in New York City for Local Law 97. I would add that under DE&I, diversity, equity and inclusion, we have major initiatives on measurement and disclosure of everything we do in our business from Board refreshment where we've been very good at that, to salary structures, training and benefits, vendor and supplier metrics. Our hiring and internship programs have been modified. Just a few of the areas in which we plan to move forward. So -- and I've already moved forward. So with that in mind, to your questions.

Maybe we'll start with the deck first. I guess a couple of the biggest changes you talked about is a time-based entry system and then also the higher per head revenues you're able to achieve. Do you think that those are permanent structures? Or you think those are helpful when you have this sort of more limited audience, but when you get back to 100% that you're going to have to put one or the other of those away?

We like the time-based entry. We hope to continue with it. We hope to continue with that with our -- not just our retail customers, but with our tour and travel -- online travel agency and past partner -- past program partners. So we've got a -- we have a limited number of slots, where we can deliver the Observatory experience that we want to. So we want to try to steer those slots towards customers who are full paying and still satisfy the demand from our OTA tour and travel, online travel agents, and tour travel and past program partners. So we have available capacity in the day. We want to make sure that we utilize that. So when we also look at, therefore, our experience -- when we are absolutely jammed, our sales and our gift shop aren't as high or people satisfaction with our experience are not as high. So we've also been able to maneuver our pricing. So our sunset hours, we've increased our -- we haven't discounted our prices at all during COVID or a lockdown or now that we've reopened. We haven't given away any freebie. Our reviews online are absolutely top. So we feel good about where we are with the Observatory. Again, to be shut down entirely and the opportunity to relearn the business, it's almost like having a stroke. You relearn to walk, talk, play the guitar, whatever you happen to do. And in doing so, get a better business model. So it's good -- a great opportunity for us to look at the whole experience after we spent 2.5 years rebuilding the Observatory while we kept it open. So very happy with our operating team and what we've got going on there. By the way, we've maintained our brand leadership. We have maintained contact with our online travel agents and our touring travel partners and our past program partners. In our downtime, we've made sure that everybody's information is up to date about us. So we feel good about our positions and ability to get back to business.

Do you feel like the new entry experience was open long enough to people realize that, that's new? Or do you think that you're going to have sort of a grand reopening or rent opening of that new experience again once we get to sort of better capacity?

So it's interesting. We've got a lot of work that we do with folks on our social and our digital and that's really how we communicate with people now. And I think that if there's any challenge, frankly, it's to our local population to remind them that we are new and different. And at the same time, one of the best things we can do is to be compared. We know what the SL Green offering will be. We've seen their presentation. We've seen maybe a little more than their presentation. So we know how we stack up there. We know what the edge is. One World Trade, it's open 2 days a week now, top of the rock. We know that they are looking at a major reinvestment there. They recognize what they've got to do, that they've got to do work there. I think we're in a really good spot. And I'd like to say dare to compare, we'll compare very well. The one thing we have to do is we have to respect people's opportunity to enjoy themselves when there's peak demand. And that's the one thing from which we've gotten dinged, and that's the one thing on which we really want to work is to smooth out the flow, even during peak periods during the day, so people have a good experience, each of them individually.

So look, I don't run any kind of lease or facility. So help me figure this out. You have peak demand at peak times because that's when people have made time in their schedule to come and visit. That's a natural flow of sort of peak demand. If you put time-based entry into place, does that really help with that time demand? Are people going to have the same issue, but in a different way where they're going to say, hey, I really wanted to go up there at 4:00, they were sold out. So now my option is to go there 9:30 or go somewhere else. And so I'm still going to leave a bad review and say they were sold out when I wanted to go. And had it been easy enough to go at 9:30, I would have done that before, and we wouldn't have had this peak conversation discussions, kind of like traffic on the George Washington Bridge. It happens at rush hour. You can tell everyone to come in at noon and there won't be traffic, but that doesn't solve the problem.

Well, let's be clear. I think commutation and tourism are 2 different things. And I do think that there'll be some degree of training by us and with us. So we will be trained as well, right? So as we fix -- see things pick up, we'll do a little bit of experimentation. We now have the metrics to understand when somebody enters and has an opportunity to engage with us to get a ticket and to go and use their pass to gain access. We'll be able to see what the difference is between when someone's offered another time and when someone has offered the time that they would like. And we'll be able to learn through the process, Manny.

So there's a question here on the live QA session from someone that must be much cooler than I am, which isn't that hard. Because they say, I see a lot of the Edge profile photos on Hinge. I don't even know what Hinge is, but not a lot of the Empire State Building. Any comments on that?

Yes. So Hinge is another place where social shows up, we -- it is -- Hinge is a little more fringe. So we try to focus on where we actually have our customers. And at the same time, I think you should expect to see us play out everywhere.

And then one other question is in here. Can you talk about competition from the other observatory like the Edge and especially One Vanderbilt? And their focus here is the location of One Vanderbilt maybe rather than the actual offering?

So One Vanderbilt will be very interesting. Grand Central Terminal is a bit of an attraction for tourists. I think what it really comes down to is Empire State Building and who's the second visit. I do believe that people will go to the Empire State Building and to look at the Empire State Building, right? So who's got the killer view? And so I really can't comment on how that works. And I also have to look at the logistics and what people offer. One Vandy, we know, at the summit we'll have that external edge you can stand on and the external glass elevator that goes up and down the side. Outside of that, it's just their own version of -- for that matter, the Edge or One World. And we'll see what appeals to whom. We don't have any of those features. Look, we're the only people who actually can offer a separate entry just for the Observatory, visitors have that museum experience and really move people through in a way that allows them to connect with something that's already in their DNA. So we'll just have to see how it sorts out.

Since you put out that -- the earnings presentation deck, any changes to your expected timing of return for the deck?

We have no update to make at this time.

What specifically do you look for in sort of determining that update? Is it the availability of flights? Do you have somebody you know in Travelocity checking when flights are coming in? Is it hotel volumes? Is it input from the tourism board? Like what is it that you're using as your KIPs or knowledge base to make that determination?

Okay. So I think for our -- I think KPIs, maybe?

KPIs. Sorry. It's been a long conference. That's what you're going to stick to me with.

No problem. I thought I might have it wrong because we're spending time on KPIs and OKRs. But that said, I think that it's -- we look at flights, seats into New York, we look from where people can travel. Good news for us, the U.K. is our number one, as we disclosed in our investor materials, our number one source of overseas travel and their program for vaccination is so far advanced from everybody else. So hopefully, will get into a bubble with them, a travel bubble with them soon. We really look for -- look, the restaurants have to open, the entertainment has to open, the hotels have to open. And then we can start to get tourists into New York again. And that's really the operative. We think that the number one reason for lockdowns and reduced capacity and everything is the fact that the hospitalization and the death rates have got to come down and the people who get hospitalized and the people who die, they're primarily older people. With those vaccines, we've already seen it begin to occur. First, it was in Israel, then in the United Kingdom. The same thing is happening in the United States. Older people are getting vaccinated, they're not getting sick. That means that the rest of us for whom, vaccination, we definitely want to get it. However, at the same time, the illness itself may not be fatal, can have more freedom to do things. So if you try to get a reservation at Melo's or at any of the other restaurants that are operating in Midtown with the reduced capacity, you can't get them, right? So the fact is people want to go out. We do believe, Manny, that people will do. In China, let's say, reopened, the phrase was revenge shopping. We think people will do revenge travel, revenge shopping, revenge socialization. And we think that people, candidly, are tired of waiting for their Peloton to show up or for their barbecue kit or whatever they've ordered and they want to get on new things. So we think there'll be a big shift. And we monitor again, flights and vaccination rates. I do think that the reopening of New York City will be much more of a light switch than a rheostat, that the vaccinations will be there. The herd immunity plus vaccinations will be there and people will return.

Going back to the comment on restaurants. Do you think that there's sort of a chicken and the egg between daytime office populations and restaurant and sort of that entertainment or dining reopening? And so the office people are saying, I don't want to just go into get on Zoom calls and talk to other people. So I'm going to wait for those restaurants and lunch coffee shops and everything else to open and the proprietors of the coffee shops and restaurants are saying, hey, I can't open until the office employees are back. And so is there that conflict there that this can be hard to resolve?

No, I don't think so. And I think that the reality is that people need to congregate, they need to get together, build -- rebuild culture, which has been really horribly hurt. Google -- the statistic out there is that Google engineers are 30% less productive than they are in work from home today than where they were when in lockdown. People want another thing from one of our very large tenants coming as our managers, want to give work to people who work under their noses. People -- another turn or people want hallway validation. They want to know that they're doing the right things. The young folks who come in, the first-year hires, they want to come into an office, be part of a team and learn. They don't know what to do. They get work at home, be onboarded through some web app, that's not success. So the bottom line is, we firmly believe that the office population will increase and the service providers will follow. Right now, in our buildings, I actually got the request from one of our tenants, look, we've put people in the office, they don't know where to get food. So we give them -- this is what's open, this is where you can go. We work in the office. Christina is on here with me. She has lunch and dinner meetings with people, and they go out and sit down and talk or go to dinner. So we're operating. And I think that's what people really want to do. I think where you have your biggest challenges is in your independent operators, and they need to see people back at work. I think the people will return back to work because the mothers want schools to open so they can get back to the office, rejoined the workforce. First-year kids want to be in, people who are first generation in an office environment, they are not working from their parent's home or country home or some are home. They're in a 2-bedroom apartment with a 3-generation household. They want to get back to the office. All of these different people who have been discriminated against due to work from home, they want to get back to work.

I thought you were going to say that when Christina can't find lunch, that's when you break out your barbecue kit and bring it to the office and figure out what to whip up.

But that would go against our indoor environmental quality.

But Manny, I would add that there are plenty of lunch options. It's not as desolate and empty. Coffee places are open, lunch places are open, business would be better if there were more -- greater building utilization. And if you wanted to get business lunch, indoor is an option, outdoor is an option. So there's no shortage based on what's going on now.

I just got a Team's message from Christina that said, "Things are open, can have business lunches, grab coffee now, not shut." So -- but I'm going to be honest. A lot of this comes from people who work from home. And a lot of this comes from people who -- like the whole conversation is, what is the office of the future look like. Landlords, tell us, what the office of the future will look like. I can tell you this thing. It's not going to be costlier services. We tried that the Empire State Building when we fully amenitized the building. People didn't want Starbucks, Akron Express delivering the Starbucks to their office. They want to go downstairs to get coffee. It's part of the socialization experience. We know how many people from -- because we've offered it, we were first in this area, how many people want food delivered to their space as opposed to go out and get it. So -- but let's talk about what people do.

Hold on. So Tony, people want to be in the office, so they can be away from the office?

People go to the office and then they like to go downstairs. Let's go grab a coffee. Let's go grab some food. Let's -- let us do this together.

Right. So I think this is what's driving a lot of the question, right? And I think the office of the future is not about the coffee cart coming through, it's not about bar service at 4:30 on Thursday, like I think that those discussions are not necessarily what's happening. I think that when people say what's the office of the future look like? They say, when you walk beyond that initial reception area, is that next conference room bigger or smaller?

But that's to what I wanted to get. So when we look at all of our plans that have come in from tenants who have signed leases previously and designed and installed their spaces during COVID or assigned leases during COVID and have designed their spaces and they submit them for us for their work, they are the same. They're the same. And you might say, oh, those are your tenants. No, we'll see. But this whole thought that landlords and architects will get together and devise the office of the future, talk to the tenant. Our job is to provide an energy-efficient building with indoor environmental quality, healthy building practices, diversion of waste, efficiency with regard to water and provide people an amenitized environment within which they can go and build out their offices and do their work. And I can just tell you, I've read Steve Roth's roundtable. He said the same thing. All of these offices that are being installed and being designed, they look the same.

So there are 2 questions here. I don't know if they're from the same person or not because all it says is anonymous when I get a question my way. But both are about leasing demand and pricing power at your price point. Are you more or less resilient than the higher price point office players? There's been some evidence of leasing at those higher triple-digit price points, but just not a lot of activity to track recently in your space.

Right. So we are doing pre-builts -- leasing pre-builts. We've got a lot of activity. That's our biggest activity is in pre-builts. We've got 4.5 lease in negotiation right now, not term sheet, but the actual lease and negotiation of one of our buildings where we were the winner because of -- and the 2 comp buildings, our indoor environmental quality and healthy buildings approach was viewed as important to the tenant. I think you're right, these big 6-figure square feet of leases get more attention. Our experience right now is that our face rents haven't changed much at all. But our free rent period and the tenant install package has increased. And that dovetails with Tom Durel's comment that we see a net -- in our last earnings call. Right now, we see a net effective rent reduction of 10% to 15%. That said, a lot of that is free rent. I think that's from people who take a perspective, but I don't know when I'm going to be able to get into my office, if you want me to assign a lease now, give me more free rent and a slightly higher tenant installation package. At the same time -- or contribution, at the same time, construction costs are coming down, installed costs are coming down. But within our environment, We do see activity it is spotty. And we do think, as we've mentioned before, Manny, Q1 2020 is the bottom. We'll return to the office in 2021, things will reopen, and we'll know where we are in 2022 first quarter. And then from there, we'll see how people experiment with this office hub, work from home, how that all pans out, right? And the interesting thing I would foreshadow also, our view is that if you look at what goes forward, from here, I think it's very, very hard to predict. Mary Ann Tighe made the comment that to look at what is happening today and project is like, and hopefully, everybody knows Mary Ann Tighe is the head of the CB Richard Ellis office in New York City, is like asking a first-time mother who's in the middle of childbirth, how many children she's going to have. You're not going to get a good perspective from a balanced view. We need to get people back in the office to experiment with this bring people back to the office, hub and home. See how it actually works. We feel pretty confident and actually very confident in this focus on ESG. And we think it will come from investors. We know it already comes from investors because of our prominence in this, because we're doing a much better job now and disclosure of who we are and what we do in this area. We're getting a lot more attention from investors saying, this is where we want to be. This is what we want to have.

Turning to the acquisition opportunities or market. When you had the conversation with Aaron, with the numbers 2, 3, 4, as you mentioned that you brought in, how are they getting incentivized? Is it deals that they're bringing to you and whether or not you make the decision to close on it, they get paid? Is it a matter of the eventual return on those deals? Sort of -- when they come in every day and they're hungry to do deals, what continues to drive that hunger?

So our first 12-month incentive is -- the baseline is up and running smoothly and with a high concentration of solicitation of off-market deals, all right? So that's point one. Point two is the continued generation of off-market deals and deals that we get to do. So the real focus, it's all return oriented, they're well aware that they compete for our capital dollar with the ability to buy back our own stock or do nothing, right? So our view is we've got 3 different angles we're pursuing. We've got office, retail and resi. We think with the resi, there is the opportunity there to buy something, which doesn't have a lot of downtime, it's not dilutive. And we go all the way to the office where we look at it and say our goal is to go in and find assets where we can absolutely gut them, replace the curtail wall if necessary, indoor environmental quality, energy efficiency, healthy buildings, amenitized, provide our suite those sustainability services as we operate and be able to lease them at a killer rent compared to other buildings, who have not been improved. So obviously, we have to accomplish a lot to get that done. I think people should anticipate that we'll lever our balance sheet off of other people's equity, our equity with other people's equity, so we can have a more broad impact and get a promoted interest from our investment that we actually make. I'll go back to you because I know we're coming down to 5 minutes, and I want to make sure you get in the other questions you want.

Just last one on that. Is he looking anywhere outside of New York?

So we want a master in New York City, what I'll call the 3 boroughs of New York City first. I don't think the Bronx or Staten Island will be much of a future for us. And then from there, we might look elsewhere. But we have to master New York City first, and we're still hard at work on that with the team.

There was a question that came in here. Earlier, you had mentioned construction costs being down. I don't think we're hearing that from other places, and this person was just curious as to some details as to why they're down.

So initially, there was the catch-up and people were overwhelmed with work that was required to be done to catch up on jobs that have been locked down due to COVID. Now certainly for what we do, which is -- I don't know about new construction, but as far as building modification and upgrade, renovation, modernization, IEQ, energy efficiency pre-built, we definitely see our costs coming down. We don't see in the future, we watch as our costs come down. I don't know if it's materials, probably not. But people's order books for the folks with whom we contract are not full and they're more competitive for the work.

Although I guess in theory, as people -- If the market is as healthy as you'd like it to be, obviously, then that should correct itself. High cost of build-out are actually a good thing.

Yes, I don't really see the -- we'd like it to -- cost to expand due to demand. At the same time, again, we think 2021 is a sideways year.

Just before I get to my rapid fire, the last question I had here was just on New York City health longer term, especially with higher earners moving away or at least in the headlines make it sound like they're moving away. some of the other issues that the city is having, and we're not clear yet that everyone just comes back. And so with the fiscal or pending fiscal issue, how NYC looks?

Look, I think, Steve Rolf said it very well in his comments. There are some question marks out there. I do believe that the radical voices have achieved the greatest prominence. If you are middle-class, working class, upper middle class, lower middle class or just not well off in general, I don't care if you're white, Asian, Hispanic, black, whatever nationality you might be. You want safe claims streets, you want to be safe in your home, you want to be safe on the subway and you want education for your family. And these are universally held values. And so we think that those feed into -- people want law and order and people who will bring the city to that as opposed to the most local voices who remain a minority, well organized minority. I don't think you're going to see a mayor win the Democratic primary and therefore, the mayoralty, with under 300,000 votes in this next selection cycle. That's just not going to happen. People are going to show up.

A rapid fire to wrap this. When we're all sitting together physically in Florida, a year from now, what will be the one thing that will surprise people the most about your business over the prior 12 months?

I think the pace of reopening the business start up once vaccinations are widely adopted and the result of revenge socialization, travel demand and the concomitant earnings contribution of the power of our Observatory. That's a unique thing for us. Our Observatory turns on with people. It's not a long lead time. We don't have to build out space. There's no free rent. There's no commission to pay.

We're going to have to trademark that revenge concept. What do you think your corporate travel budget will be in 2022 as a rough percentage of what it was in 2019?

Well, we're New York City-based. However, what I will say is we expect social -- we'll spend more on socialization with brokers, tenants, finance partners. And we expect that will come back strongly. I mean we already continue to meet with these folks. Our number one relationship in Qatar is in our office today at 6:00 p.m. He's been vaccinated and he's coming in for a meeting. So I'll be in Doha soon. We will continue to go out and meet people and make those efforts.

What will same-store NOI growth be for the office sector overall in 2022?

Okay. Your guess is as good as mine. No idea.

And what will the 10-year treasury yield be one year from today?

If we are lucky, north of 2%. If we are not lucky and it's lower, I think that means that the business environment has not picked up, that demand has not picked up and that we fall in backwards again.

So Christina, what number are you throwing in your model, 2%?

I think it will be around the same, that's my guess.

Which one do we put into our survey, Tony?

Well, I think you could say 1% or 2%.

Great. Thank you very much. Enjoy the rest of the conference.

Thanks.