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

Good morning. This is Steve Sakwa. I am the senior REIT analyst at Evercore ISI. I'm very happy to be hosting senior management of Empire State Realty Trust. Joining me this morning are Tony Malkin, the CEO; and Christina Chiu, the CFO; and Tom Durels, Head of Leasing. I am going to lead a short Q&A discussion with management. There is a chat function at the bottom of the Zoom session here. [Operator Instructions] So first of all, thanks for joining me this morning.

I guess the big question is obviously the reopening of the gateway cities and how that sort of dovetails into leasing. So maybe, Tony, if you could just sort of start with what you guys are seeing on the ground as it relates to tenants returning to the big cities, in particular, New York, how your buildings have changed in terms of utilization and what we can maybe expect between now and Labor Day.

Well, thanks, Steve. I'll start off with a few start-up comments, if I may, and then get to that question. First of all, welcome. Very happy to remind our long-term friends and acquaint our new members of the audience as to who we are and why we represent a compelling investment. We own and manage 10.1 million square feet in Manhattan Greater New York Metro area office retail, that includes the Empire State Building. We have modest leverage, $567 million in cash plus $850 million in our undrawn and 4-year, renewed recently, revolving credit facility. That's as of the 31st of 2021 March. No outstanding debt maturity until 2024. Our portfolio is primarily a collection of Manhattan office properties, which are fully modernized, energy-efficient assets with indoor environmental quality. And we're centrally located near mass transit. We rent at a substantially lower price point compared to new construction Class A, and we offer much more in Class B assets. So that's our niche. Our Observatory, which completed its renovation before the pandemic hit, reopened in July 2020, one of the first attractions in New York City to do so. With vaccination progress, visitation grows steadily off a low base, but really quickly, more recently. And we're getting very strong feedback from our visitors. We have long said that our Observatory represents tremendous benefit for instantaneous reaction to economic activity and the recovery of travel, and we see that now. We're leaders in energy efficiency and ESG, and we continue to lead the industry from the front. Just a few recent examples include we're accepted into New York State's Empire Building Challenge, and we received our first grant there. That's to serve as real-life case studies in the development and implementation of innovative decarbonization strategies and technologies. Our inaugural sustainability report was just published, ESB, which will be revenue -- excuse me, carbon-emissions-neutral, net zero by 2030; the entire portfolio by 2035; and we were awarded the ENERGY STAR Partner of the Year designation in 2021. And finally, our entire portfolio is 100% powered by renewable wind energy. So I would say that right now, for our fully modernized portfolio, at our price point, we're in the midst of and benefit from a nationwide and local New York City recovery as observed by the steady cadence of positive data points: Increased corporate announcements and return to office plans really speeding up from what people had said even a month ago and building utilization, air travel, velocity of the apartment rentals, New York vaccination rates. We're told that this week, the governor will announce New York has reached herd -- New York State has reached herd immunity, which he's -- targets at 70%. So we're well positioned with our $43 million of embedded upside growth and our track record of great results, recovery of our Observatory business as tours and traffic returns to New York City and our balance sheet, which gives us the opportunity to take advantage of growth opportunities. People have been stunned by the efficacy of the vaccines. It's caught people unprepared, and that means rapid changes to plans to return to office. Right now, we're -- as of last week -- actually, the week before, I don't have the stats for last week yet. We're 16% building utilization compared to pre-COVID levels. That's an approximately 50% improvement over the last month or so. The Greater New York Metropolitan area, we're close to 40% building utilization. Our tenants are focused on return to office through July and September, but the numbers continue to increase as people recognize there really are -- the conditions are safe. The vaccine works. And by the last survey, by the partnership with the city of New York, the CEOs -- and that's about a 2-week old survey -- CEOs anticipated 61% of employees back by Labor Day. That number is 20% higher than the last survey just a month before. And I think that the next survey will be higher. So many of our tenants comment about the benefits of employees being together: Better collaboration, creativity and productivity. And I think what we're really seeing, Steve, is similar to the March, April, May stories of 2020 when everybody focused on will the office ever come back. Now it's the recognition, no, people are coming back. Mask-free mandates within the offices for vaccinated workers. The world has really changed, and we're happy for that.

Great. Let me take those comments and maybe bring Tom into the discussion as it relates to leasing. And I'm curious kind of what you're hearing from tenants in terms of either renewals, but maybe more importantly, new transactions that you're in the marketplace looking to secure to boost the occupancy rate of the portfolio. And what are you hearing from tenants as it relates to space needs, density per person? How will those things sort of change maybe from prepandemic to the conversations that you're having today with both new and existing tenants?

Sure, Steve, we're seeing a number of very positive recent trends. When I look at our tour -- starting with our tour activity, in the first quarter of this year, our tour activity was running at a run rate of about 40% of our 2019 or pre-COVID levels. And then the first 2 months of the second quarter, we saw tour activity running at about 2/3 of the 2019 or pre-COVID levels. And then if I look at just the last couple of weeks, that's ramped up to about 75% to 78%. So you see a positive trend of increase in tour activity. And while those tours will likely lead to proposals only in the second half of this year, it's a really good sign that tenants have reengaged and are focused on space search. We've seen a significant increase in our prebuilt tours. Of course, we have about 270,000 square feet of prebuilt space that's built and ready to lease. And if I look at the activity, measured by the paper being exchanged, either leases in negotiation or just proposals being exchanged, we're actually exceeding our pre-COVID levels for the small suites. Again, that -- those -- some of those transactions may not show up until the second half of this year, but we're seeing a really good positive overall trend. We're seeing a mix our of -- interest from a mix of tenants that ranges from professional services to legal, financial services, tech certainly is out there, some nonprofit, media and government. On space use, we really haven't seen any specific examples of tenants taking additional space to either de-densify or to reconstruct their space. Very much there's -- folks are looking past the vaccine. And there's an awful lot of speculation and discussion on the topic. We just haven't seen any radical change in office design. We have seen some modest de-densification of furniture layouts. And I think tenants are focused on collaboration space, amenities, whether it be lounges and soft seating and quiet areas and certainly, food for their employees and providing employee perks as they look to entice their workers back to the workplace, and they're very much focused on employee health and productivity and engagement. And then certainly, tenants look to us to provide solutions on the employee health and the IEQ aspects. Indoor environmental quality is the #1 issue that is asked about. It's certainly a gating issue for many tenants. In some cases, tenants won't tour unless we've responded to a number of questions and provided answers to solutions about our IEQ specifications. And so it's very much front of mind, and I think it will be for the future, and it's here to stay.

Well, you raised a good point, and Tony has talked about the modernization. And look, you guys have spent $1 billion on the portfolio for a whole host of things from the lobbies to the windows to the HVACs and fully modernizing. I'm just curious, when you talk to tenants today, what are at the top of the priority list for them versus maybe what was at the top of the priority list when they were looking for space, say, 2 years ago, pre-COVID? How has that changed?

It's funny, Steve. We were at dinner last night with one of our agents. And look, they want modernized. They want value, they want clean air.

Right. So I would say that on the sustainability front, there was certainly a focus on energy efficiency pre-COVID. And the whole sustainability package, it includes indoor environmental quality. And today, it's clean air, indoor environmental quality, MERV 13 filters, bipolar ionization, HVAC systems, fresh air supply, what are -- and certainly focus now and there are -- tenants are educated on things like ASHRAE standards and the specifications within our building.

So the other thing I would say, just to add to that is, we have a proposal that we are entertaining right now from a government prospect. And the list of questions about energy efficiency, certifications, DE&I, for the S part of the ESG, it's a major area of focus. I think it's important to note, not only are we leaders in this area, we've sort of defined the waterfront. Our work practices have established what's now known as ENERGY STAR for tenants. Our work practices have defined how you reduce energy consumption in buildings. So we're in a very good advantage in this area.

I would add to that. I think that the things that we're hearing from brokers as we were at dinner last night was -- a group of brokers that we are viewed as the industry leader in this area, and folks in the industry and brokers and tenants look to us for the answers and solutions that we provide them.

Okay. Now there is a question coming in from the audience. So let me weave that in, and then I'll jump over to the Observatory. And I don't know what you're hearing or seeing on this specifically, but let me throw it out. Early on, there was a lot of talk about companies leaving New York. There are people leaving New York, going to the Sun Belt, whether it was Texas, Florida, certainly for tax issues, and there's been some high-profile individuals that have moved to some of those more tax-advantaged states. But I'm just curious, Tom or Tony or Christina, when you talk to tenants, how are they sort of looking at New York versus maybe some of these cheaper alternatives in terms of rent, running their business, lower-tax states? Has that sort of subsided? Has that not really been an issue within your portfolio? How would you sort of describe that?

We haven't seen -- I can't think of a single tenant that has moved out of our portfolio to move to the Sun Belt or out of state. Certainly, the small suites, the smaller tenants who are more nimble, and we're able to work from home during COVID, but what we're seeing is the reemergence of those tenants, as evidenced by the tours and the proposal activity that I mentioned earlier, from those small tenants so that they are coming back to the city. But I can't think of a single instance where we lost a tenant because they moved out of state. Certainly, there have been examples of some contraction, that in some cases, we've been a beneficiary as one large tenant I can think of actually gave up space in somebody else's portfolio and moved into our portfolio. But we also, as you saw in the first quarter, our 3 largest leases in the first quarter all represent employment growth and growth in footprint here in New York City. That was Zentalis, Belkin and Burlington all expanded during COVID.

So I would add to that, Steve, that, again, just from our dinner with one of our agents last night, there's a significant amount of sublet space that's been taken off the market, which doesn't mean it's been leased. It means people have said, okay, wait a minute, I put it on the market. I actually do have to house these people. And then there's another interesting phenomenon. As people grapple with this mix of work from work and work from home, there is a REIT, which we'll announce, I believe, today, a retail REIT that it is going to a 3 days in, 2 days home, 2 days home is optional, 3 days in is mandatory, and it's 3 days all at the same time. So they're not going to need any less space. They'll -- everybody will still maintain their offices. And I really believe this is an area that is in flux. And I really believe that the difficulty here is to respond to the immediacy. At the same time, you have to think about the broad field of play. It's a little bit like going skiing, if you spend your day looking at your boots, you don't look at the whole day. And so we need to respond to make sure that our boots are clipped and they're good in our bindings and deal with the immediacy of the moment as well as for the longer term where the trends would indicate slightly different from the headlines. I'd also say that the area where most people have moved and be capped are very high wage earners. And that's what's caused a lot of concern. And at the same time, those hedge funds and private equity firms have been the biggest leasers of space so far year-to-date in 2021 at the highest rents. So there's a lot of, I would say, confusing data out there for us. We look at our -- the offers we're exchanging and the paper that we're actually generating as far as leases and leases signed and it's early. And at the same time, we would think that the death of this is greatly exaggerated.

Okay. I want to just transition to the Observatory because it's obviously -- well, was a big contributor to the cash flow of the company before the pandemic. Obviously, you had to close it for a period of time. It's been back open, but it's been heavily tourism-driven, and with international tourism still slow, that hasn't ramped up. But can you provide us any sort of commentary on what you're seeing so far in the second quarter here? And kind of what are your expectations for the summer into the fall?

So as you know, Steve, we don't provide intra-quarter updates. That said, we remain very comfortable with our hypothetical assumptions. And what we had projected, local visits first, regional visits have begun. And we've got long-distance travel from within the United States coming into the Observatory. So from our actual results, and there is nothing which would cause us to revise down our assumptions that we've made in our hypothetical projection of return, we continue as we noted in our prior presentation of results in -- after the first quarter, while the numbers were low, the per caps were very high. Per caps continue to be quite good as far as our revenue per visitor. And we feel good. We're very -- let's put it this way. We are happy that the governor and New York City have begun to relax capacity constraints because at certain times and at certain moments, in certain areas of the Observatory, we need that capacity. So certainly, on 102, we need that capacity. And so at times of day -- we're not at the point yet where we are changing our expense assumptions on the basis of requirement. So that remains where we had set forth in the -- in our earlier discussions, and any update on that we'll provide with our quarterly results. And I do believe, Steve, a very good proxy for what happens is anybody who gather the airline seats into New York City data. That's what we follow the most, not number of flights, but number of seats into New York City because if you recall, they were using smaller regional planes. Bigger planes are begun to be used again. There's more travel into New York City, more hotels are opening, and that means we can look at visitors from further away who have to have overnight stays. And I would add to that the fact that our brand is absolutely intact. And that's one of the reasons we opened early in 2020. And that's how we've managed the brand and the building. So we have a very good national brand, very good international brand, and we have no change to our hypothetical reramp.

Great. A question did come in. You sort of -- well, there was 2 questions. One, you sort of addressed on sublease. So it sounds like sublease activity is starting to go down in the city. It's still probably an issue, but maybe not as big an issue was sort of the first question. And then second, there was a question, I guess, around keeping the ground floors and basically the retail space within your buildings leased with quality tenants. So maybe just speak to kind of what you're seeing on the retail side of the portfolio. And maybe concessions that had to be granted, are those starting to kind of burn away? And are you starting to be able to fill up any vacancy on the retail front?

I'd break the retail down into 2 parts. One is the larger national or international high-credit tenants who occupy space with us under long-term leases and then the smaller local players that are sort of predominantly food retailers. And all of the larger-credit national, international tenants continued to pay rent through COVID. And then for the smaller local tenants, and again, mostly who are food operators, we converted their base rent to a percentage rent through the -- mostly through the end of this year, and that was to help facilitate their return to business and their survival through COVID as their customers have left the city, and now they're beginning to return. It was good to see, at a restaurant last night, there was good activity. As I've gone to either lunches or dinners, I'd see that people are anxious to get out and kind of get to a social environment. Again, we're seeing a positive trend in the food environment. We are active with a handful of proposals, renewing some existing tenants. Again, some of the smaller local players as well as a national truck food operator. We've got an actual proposal from a home goods and accessories company. So we're seeing some immerses of activity, but it's still slow, and it's early. I think that -- look, the customers aren't fully back. And when they do return to the city post-Labor Day, I think that we'll see the reemergence of retail activity follow suit.

Okay. And one last question before I switch to just transactions and just what you're seeing on the investment side. But are there any changes in the lease terms? Are tenants looking to do shorter deals today to have more flexibility? Are they willing -- given the drop in rents and higher concession packages, are they willing to lock in longer-term leases? Are you seeing anything from tenant behavior on that front, Tom?

Well, it's interesting. Kind of a mixed bag. If you look at the leasing that we did in the first quarter, we had an average weighted lease term of 10 years. So we thought that was a really good outcome in the first quarter, but we have worked with some tenants who were looking for short-term solutions. But -- and we've seen some situations where tenants are looking for a termination or right to terminate, say, in year 7 on a 10-year deal. But I can say it's consistent across the board, in any situation where we do agree to a termination right, it's going to be contingent upon payment of unamortized costs and penalty and interest. So there's a bit of a mixed bag out there. I can't say that every tenant is looking for flexibility. Certainly, there are tenants that are looking for long-term solutions. They're taking advantage of the current market. They know that their future home, their workplace is in New York City and will be in New York City. They're thinking past COVID, and they're looking at solving their real estate solutions for the long term. And so I think that any tenant that's locking into a lease today is getting a favorable deal. It'd be interesting to see where we are a year from now as activity has picked up, and folks may have missed that window.

And one thing I'd add to that, Steve, is it's a little bit self-selecting. People know that we may look at a 10-year lease with a 7-year out or a -- and a smaller space, a 7-year lease with a 5-year out. People have to pay to get out, if they want, our unamortized expense and an interest factor. That said, people know we won't do these very short-term deals, and therefore, they don't come to us. And I think there is an effort by -- and I don't know about so much is. There was an effort by brokers, in order to generate terms -- excuse me, generate leads, to go to prospects and say, well, we'll go and propose a 3-year lease with a full build-out and the right to contract and this, that and the other thing. And those first proposals, we get a number of first proposals in and -- which are like that. And the fact is the broker has either solicited on that basis or the broker said, I got to because my tenant has said, do this, put this out, please respond with your deal. And we're still doing deals.

Got it. Well, I know we don't have a lot of time. I think we got 1 minute. But Tony, anything that you're seeing on the investment side? You mentioned your strong balance sheet. Has there been any distress? Have you found any interesting opportunities for the company to deploy its excess capital?

So look, we continue to focus on office, retail and multifamily, increased number of deals on the market. There's a lot of capital in the market, and we are active and remain disciplined in our underwriting process. So we are actively bidding, and we are involved in ongoing processes. I would say distress is not what the story is. I would say there are motivated sellers now. Some of the folks, families with whom we wanted to do things in the past are now looking around. And as I've said in the past, they felt a little nervous, and now there are some families who are transacting.

Got it. And would that be because of the environment? Or would that be more kind of 1031 or potential tax changes that are kind of motivating these people to potentially do a deal?

I would say it's F, all of the above, and you didn't mention D and E. So it's -- I think it's very simple. When the market changes -- as I said before, people felt confident. When the market changes, they don't feel confident. And with families which are remote from the business that they do, that swing is very big.

Got it. Well, I think we're up against our allotted time. So I want to thank Tony, Christina and Tom for joining us and talking about New York, and it's great to see activity picking up and look forward to seeing you in person.

All the best. We're here. Come on by.

Thank you.

Thanks, Steve.