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

All right. Good morning, everyone. Thank you for joining us. My name is Jamie Feldman. I'm the senior office industrial -- and industrial REIT analyst here at Bank of America. We are delighted to kick our office segment of the conference off with Tony Malkin, Chairman, President and CEO of Empire State Realty Trust. We're going to spend the next 35 minutes with Tony, talking about what's going on in the New York City market and his thoughts on the world at large. And just so you know, this is prerecorded. So today is actually September 17. So if there is any information that comes out on the company or on the market over the next couple of days, we just want listeners to be aware that our conversation is dated as of that date. So Tony, thank you very much for joining us. It's a pleasure to see you. We appreciate you participating in our conference. I guess just to get things started -- sorry, go ahead.

No, go right ahead. You go.

Okay. I mean just to get things started, a lot has happened in New York City, both on the office side, on the tourism side since we last spoke. So maybe just big picture, if you could please characterize what are your thoughts on where the New York City economy stands today, the New York job market and even the office market? And then we'll dig a little deeper.

So first of all, thanks, Jamie. I might go over just a couple of intro points about ESRT. 10.1 million square feet Manhattan and Greater New York Metro area in retail -- office and retail, includes the Empire State Building, of course, our world-renowned Observatory. Primarily, a collection of Manhattan office properties fully modernized with energy efficiency and indoor environmental quality leadership centrally located near mass transit. Our office portfolio provides a value proposition for tenants who are in the market for space at a lower price point than new construction and aged Class A buildings, but offer far more than your typical Class B buildings. Maybe to address your comment, our visitation to our Observatory continues to be well ahead of 1 and 2Q and at record levels per visitor while we manage the business in a disciplined manner, remain focused to provide our visitors with a world-class experience. This is visible in these record levels of revenue per cap and our 5-star customer reviews. We have to admit, both for the Observatory and the market in general, the impact of the Delta variant, and I might say probably more the impact of the craziness of the Delta variant on domestic and international travel is widely recognized, and we're not immune to that. The hypothetical admissions forecast that we provided in our investor deck is intended to be helpful in modeling and we will update it accordingly. That said, we are encouraged that the EU and U.K. large concentrations of our top 10 visitor points of origin for us and for business in general are now in excess of 70% fully vaccinated for eligible adults. We think that's really important for tourism and business, and we are confident that the United States government will get around to a reopen of our borders to foreign tourists and business visitors soon. We continue to manage the Observatory to maximize growth in revenue per cap with tight expense management. Just another thing on the Observatory. We have extraordinary high operating leverage with the immediate bottom line contribution and zero correlation to the office business, and I think that differentiates ourselves. We align expenses with visitor volume. We really don't have CapEx needs, and that goes 2 ways: number one, given the full scale redevelopment we completed just prior to the pandemic, which positions us excellently to compete with the new entrants into the observatory space in New York City; and number two, unlike office and retail, there's no lag time between the time of a resumption in business in the Observatory and a flow to the bottom line. One last comment or two. Our balance sheet is $1.4 billion in liquidity with over $500 million in cash and the balance in an undrawn credit line. We can evaluate opportunities to deploy capital for external growth as well as engage in the repurchase of our shares. Finally, we're very focused on external growth during the current period. As we have said before, our targets are office, residential and retail in our current markets. We exercise prudence in our capital allocation and focus on the creation of long-term shareholder value. I would say that I have stated repeatedly for more than a year that I don't think we see the bottom of this current cycle until the end of the first quarter of 2022, and I haven't changed my view on that. New York City's recovery and an ability for at least the vaccinated to live with COVID-19, I think, are closely linked with New York City probably more advanced than a lot of other regions as far as the ability to live with it. And I think that's a really important piece. The COVID-19-related restrictions on our ability to do business have been greatly reduced, and all of these activities have led to more tours where we can actually do tours now, where we actually get people come into the office. We get smarter people who are really focused and clear on their long-term goals and objectives are the people who come to us and look to lease space. I would also say that as far as the job market is concerned, really topsy-turvy. There's a lot of upset, I think, in folks who would like to come back to the office. People would like to know what they are doing. I think the return to schools, full time schooling is critical for the New York area because that makes it possible for everybody to have the flexibility to come back to the office. I think we'll see changes as far as people attending office. However, we still do see job seekers out of college flock to New York City. We see the increase in the rental of residential apartments. And we see the fact that these apartments -- a lot of these apartments are leased by young, new, either job seekers or job takers. Folks did not sign up to work out of their apartments, they sign up to become part of culture, to be trained and to start their careers. So we think we see early positive signs as far as both on the office side, the fact that we do see deals underway in our portfolio, expansions, extensions and new deals. And we also see, really up until the confusion around COVID, we had grown to a point where we had about 30% of 2019 office occupancy in our portfolio and then we were close to 50% in the Greater New York Metro area, about 30% New York City and that had steadily climbed. We saw a setback at the beginning of this Delta confusion, and we've seen it grow again actually over the last 2 weeks. So we're hopeful all this stuff sorts out. The big picture, and I'm sorry for the long intro, I'll try to be more concise on the next answers to your questions, we really think it's the end of first quarter '22 that the whole dialogue will change and the -- and things will improve. We're still going through the dip and the mess at the bottom of the dip.

All right. Great. That's helpful overview to get us started here. I guess just to one of your points on the leasing activity you are seeing, I mean what would you say is the latest conversation with tenants who are either signing new space or looking to renew? What are their -- where are they in terms of back to the office? How many days a week? And how are they thinking about the space they're going to need going forward?

So it's really interesting. We, for the first time, have begun to see new configurations in tenant fit-outs. And again, I keep going to our smartest and best and capitalized tenants. And I say that because I think it's important to distinguish between folks who are confused about what to do and I think it's also folks who have business models where people are completely overwhelmed with work right now. M&A, IPOs lawyers and bankers have never been busier, and I think that's a big component of the combined monetary and fiscal stimulus at the same time. But when you look at the people who are making their decisions right now: more creative spaces, more convening spaces, more space per employee, a reduction in the whole concept of benching, a reduction in the whole concept of pack in as many people as possible. And when you look at the tech businesses who really have -- and these are the real tech businesses, not the start-ups, who really have given a lot of thought and analysis, they want to make their offices a place where people want to convene. They want to make it so exciting, so dynamic, so meaningful to be able to be there and get together with your associates. And I think that's very exciting, and I think that's probably the future.

Yes. It's interesting. I mean we -- our team has been back to the office for about 1.5 weeks now and one of the consistent piece of feedback we're getting is just, it's great to be in the office and see everyone, but it's actually hard to get your heads-down-work done. And I know over the year since COVID started, whenever we talk to Gensler, there is a big -- as people are planning, they think a lot about heads-down-work versus collaborative work. What are your tenants saying about that? I mean what's the best way -- if the focus is being together, socializing, collaborating, what about the days where you just need to get work done? How are they thinking about where people should do that?

It's really interesting because we see them, the tenants who are taking space right now. Number one, we have our typical prebuilts, which now are all -- when we do a prebuilt, people get the -- what we call, our IEQ certified, or Indoor Environmental Quality certified, so not just at our office spaces are energy efficient. As you know, we were leaders going back to the SARS virus that we were focused on MERV 13 filters, ventilation, active bipolar ionization. So those tenants who come in, we can't really be clear, unless we fit out the space for them, which is one of the things we will do, we'll actually provide office furniture, how they'll lay out to accommodate that heads-down-work piece, as you mentioned. But in the new spaces that we see from banking where we're seeing tenant activity, in the med tech and medical space, and that's not labs, that's offices, in the tech space, in fintech, these are the folks who are moving -- who right now have moved forward and they want to take spaces, what we note is a lot more private work area, conference room area. Remember, we had gotten to a point where the typical TI involved just an immense amount of benching and some meeting space. When we built our offices at ESRT in 2016, we made clear we had more seats in conference rooms, small breakout and private work areas than at-work desks. So that's part of the, I think, what we see in the future. The other thing which I think is really interesting is that people have to get back into a rhythm where they are more productive at -- people worked and do work much longer hours in work from home and they've got a whole bunch of distractions on their screens. Maybe they have their music. They're not accustomed to people around them. They've lost the ability to socialize and to work in a socialized environment. So I think it's important that people recognize, number one, is people retrain to be able to work with someone near them, that they'll be able to hear something. I've been in the office since June of 2020, haven't really had that issue, number one. Number two, I do think that we will see more fit-outs of people working with -- in office environments, new office environments, more breakout and private workspace.

Okay. And you had mentioned potentially more space per employee. I mean are you seeing expansions? Or if you were to look at your leasing pipeline today in terms of renewals, new leases and expansions or contractions, how would you -- if you boil it all down, is it a net positive, neutral, negative?

Right now, if we looked at what we actually have in the current hopper and we combined new leases and we combined expansion and then we combined renewal into a chart -- a pie chart and try to break it out, the biggest volume by number of new leases are in our prebuilts. We see a lot of folks trading up specifically because of IEQ and energy efficiency and location and the modernization of our buildings. So we see a lot of activity on the prebuilt side. On the new tenant spaces, we have a bunch of leases we will announce soon. Those -- as far as new beyond prebuilt full floors, those are a variety of different users. And still, though, I'd say just by coincidence, right now, the biggest amount of volume of square feet that we have leased or lease discussions underway is an expansion. So dollar -- by number of tenants, it's on our prebuilts. By dollars and space volume, its expansion. However, full floor new leases are close behind. So we have a lot of activity underway. It's very busy.

So for the -- I mean would you say it will be a meaningful pickup in your occupancy level based on the pipeline?

That sounds an awful lot like a forward-looking statement. What I would say is that we have, for the balance of this year, more leases contracted for to take occupancy than tenants who will not renew. So we would expect to see from this point forward just on the basis of tenants who are not renewing versus -- and I've got a statistic that I had prepared for this, if I can try to find it for you. And it's -- I've got too many pieces of paper in front of me, sorry. But the bottom line is that we do see more in the way of contracted for leases that's not even a mention of the leases that we have in negotiation right now than folks vacating. So we would expect to see our number just based on existing business in our pocket -- occupancy go up, lease percentage go up.

Okay. That's good news. And then the tenants who are new to the portfolio, I mean, where are they coming from? Do you find that you're stealing from other tenants? Are there -- everyone's been talking about the kind of haves and have-nots in the New York City market. How is that dynamic playing out for your portfolio?

We really see people who are driven to us by the primary intro comments that I made. We're very well located. We're modernized for the 21st century. We are leaders in energy efficiency and Indoor Environmental Quality. And we produce a work environment candidly where, if you want to find all of those attributes today, you have a choice of us or paying triple digits in rent in a brand-new building. So if you hear about One Vanderbilt or One Madison, these newer buildings that are either finishing up or underway, they talk about distributed antenna systems. We have it. They talk about MERV 13 or better filters, we have it. They talk about ventilation, we have it. You talk about energy efficiency, we have it. You talk about active bipolar ionization, we have it. The difference is that we are accessible to a far broader group of tenants. So we're coming from -- we're getting folks from all over. Typically, however, what we see is just like the new buildings. We see people trading up from older buildings that are not improved into our portfolio.

And then in terms of rents, I mean, where would you say net effective rents have moved in the portfolio? And how do you break that out in terms of face versus free rent versus concessions or CapEx?

So what I'd say is that the big issue is, for us, we haven't seen much in the way of change of actual capital outlay. We're still in that sort of $120 a square foot for turnkey -- $105 to $120 a square foot for turnkey, depending upon the space. We have our base building to add to that. Seen a slight uptick in cost, but we see a decrease in, I guess, the profit margins, which contractors are taking in order to get the work. That's part one. Part two, overall, we really look at a sort of, depending upon the space because everything is different depending upon when it rolls, a 10% to 20% reduction in net effective rent. And the biggest cause for that, frankly, is rent. And then the next cause for that, I would say, would probably be the concession, the free rent, though that has begun as people see greater clarity towards when they actually get to move back into an office to decline. And then there is the CapEx, which is more fixed, more constant with what we've seen in the past.

So you're saying a 10% to 20% reduction primarily in face rents. Is that the right way to think about that?

It's a 10% to 20% reduction in net effective rent with the greatest concentration coming from rent and free rent.

Okay. And then...

And by the way, within that, we haven't changed our credit standards. We really haven't seen significant change in term. Some request for lease cancellation where we might grab it in the seventh year of a 10-year lease or the tenth year of a 15-year lease with economics. They have to pay us unamortized cost. Our secure deposits have not changed. And so we're not really -- we haven't moved heavily into flex space and the provision of flex space. That's not what we'll do in our portfolio. That's not the people who come to us.

Okay. I mean it seems like such a focus among you and your New York peers has been holding that face rent. So would you say something's changed? Or I guess you can't fight the market. You can't fight where the market stands after a point once leasing starts to pick up. Am I thinking about that right?

I think a lot of the newer buildings have focused on -- new construction specifically has focused on big face rents with less of a concern about the free rent, the TI, the base building, CapEx that they put in because they want to get a very high print for their financing. I think we've seen that in some recent new buildings and redevelopments. From our perspective, candidly, we really just go with where the market goes. We don't try to manipulate our rents towards a face number for a print. We want to go with where our tenants want to be, and our tenants are -- they're the ones who really guide the discussion for us. We don't look to say, hey, look, we'll give you this net cost, but we need a really big print. We say to them, what's the best deal that you'd like to structure, and that's what we have found that it's the characteristics, the components that I've referenced to you.

Okay. And I know you mentioned in your answer some of the changes in lease -- parts of the lease. Like what do you think coming out of this we are going to see differently across the board? Like what do you think will be standard in New York leases post pandemic in terms of whether it's early terminations or anything else that seems to be becoming more commonplace.

Jamie, I really have a completely different view of where we're going in a lot of the market. I really believe that the true impact of this trough through which we go right now will produce a very, very interesting effect come '23, '24, '25. There have been a lot of decisions, which have been short-term extensions. There have been a lot of decisions that have simply not been made. We've seen some people -- smaller businesses return to home. We've seen larger businesses take a look at -- one of your competitors, or maybe you wouldn't think they're a competitor, but another institution with -- a Canadian bank, if you're not senior, you don't have a desk. You've got to reserve a space and you can only reserve a certain amount of space for a certain period of days in a month. I think we'll see a very different story in '23, '24, '25 as decisions that have been put off combined along with decisions that have been shortsighted for lesser space, combined with normal roles that take place at that time, and I think we're going to have a market that snaps back very strong. I think we've got a ways to go until we get there, I really do. But I think we'll begin to see that snapback and we'll see a much bigger demand in that period of time going forward. So I think we're in an interesting trough now where I think things settle out for '22 through the bulk of '23 is pretty much where we are just with higher volume. And then people will realize, wow, we didn't make the decision we needed to make. We didn't take enough space. Other people offer everybody. So some of our tenants, even if they're going to go to hybrid and many of them will and many of them have decided they will, they have said we will provide a workspace for every employee whether they're there or not. And I think that these are the smartest folks and I think a lot of people are on their back feet and they're not thinking and they're making decisions based on yesterday's issues, not what's coming in the future. It's going to be important to provide and attract -- to attract talent to provide a great workplace.

So you think people are -- it's a little bit of a knee-jerk reaction. They're cutting too much over the near term, and they're going to have to bounce back. Is that what I'm hearing?

Yes. I believe that there is a part of the market, which has only looked at this as we're getting our work done, we don't need the space. And those are people who I think are, frankly, a lot of bankers and lawyers who are overwhelmed with business right now. I don't care if it's IPOs or M&A or debt financings, they are absolutely overwhelmed with work. They don't have to go out and compete for work. It's a question of how do they get the work done. And then there are the folks who are the growth businesses. You've heard about Facebook continues to want to look to take new space. Google continues to want to look to take new space. We have a tenant in the Empire State Building, LinkedIn, which we truly expect that based on discussions when they took their last spaces with us and their leases with us that they would sublet some of the floors they have because they moved to larger floors, which would be more accommodating to the work environment they wanted to have. They have -- at least who knows what will change over time, right? But what they have told us is they're going to build out all their space. They're not going to put any space on the sublet. And what they really want to do, they've stated their policies in public that they will allow workers a lot of flexibility. And what they've decided to do is to make their workspaces so attractive people will want to come in. It's an inducement for people to come and share and collaborate. And I think that's really the moat of the future. And I think that people given the opportunity to work partially in the office, partially not and told when you can't show up, you can certain days, employees won't want to go there. They want to know if I want to come in, I've got a desk. I've got a place to work. I've got a place to meet with my peers and my colleagues.

When do you see -- when do you think we're going to start to see some big leasing get done by the big tech companies? I've heard that more and more lately that they're not sitting on their hands, but how long do you think they're actually -- before they're actually ready to commit?

Look, it's not my tenant, but I can tell you, obviously, in the market, 770 with Facebook is already in the works. I can tell you that from our perspective -- look, how do you define big tech. Don't forget, when we signed LinkedIn, we took them from a 4,500-square foot subtenant on one of our -- in one of our floors in the Empire State Building and now they're hundreds of thousands of square feet. So what we see, we have certain tenants will announce leases that we've got expansion in the fintech, med tech space. That's happening. It's underway. Their businesses are growing, they're getting funded, they are expanding and they need more space.

Okay. I want to shift gears to the investment market, given I think you have a contrarian view here with things kind of bouncing back in '23 through '25. We saw Columbia trade, I'm curious what you thought of that transaction in terms of pricing. And then also just with this contrarian view of the market and you've talked about putting capital to work, what are you thinking now in terms of what you can see out there to invest in?

So I'll take care of the second part first because it's much -- I think much more simple. We continue to work on primarily off-market transactions in office, residential and retail. And that's our focus in the New York City and Greater New York Metro area. And frankly, where we see the best opportunity right now, we recognize office is a very highly capital-intensive business. I love the juxtaposition of our Observatory business with our office business. You couldn't have 2 more opposite businesses. Literally, the moment somebody puts a -- buys a ticket online from us in the Observatory, and by the way, most tickets are being sold online now because we've gone to schedule visits right now, no longer just across the front door, and that's making us a lot more money from our clients, our visitors. The office business is the exact opposite. The client shows up and right now if you sign a lease, particularly a new lease, it could be 2 years, 2.5 years before you see revenue depending upon -- you sign the lease, you've got to wait for the lease to become effective date when they actually take the space. You got to do the build-out and everything. It's just completely different. Retail and residential are between those two, between the Observatory and office. So we are very focused on what will be accretive to our shareholders, and we're very focused on what will deliver the best bottom line result from a cash flow perspective as we look at things, number one. Number two, CXP. This is a very odd deal, namely, you have a very low leverage transaction meaning I don't think it's very replicable. You have a very low leverage company, okay? And that's very important because the deal on that by the acquirer is they are levering up this portfolio by a lot, number one. Number two, you have a very unusual situation with PIMCO and Allianz. Allianz really controlled, to a significant degree, big pieces of the value of that asset and they had a lot of control as to what happened with it over time because of their joint venture. So you had folks -- you might even say, and to some degree, that Allianz averaged down their cost by the participation in the transaction because of their joint venture positions that they already had combined with the leverage. And if you look at the -- and if you get insight, I don't know what you have with regard to the PIMCO view, it's like a 5-year hold for them the way they underwrote the transaction. So I look at that and I say, look, I think a lot of Boards have lost faith in the direction of their businesses. I think clearly that the Board of CXP decided it was time to take over the process. I think there are other REITs where you may see Boards, which historically had been intimidated by management. And the good news for me is -- and for us at ESRT, we have never managed our Board in that way. Our Board is super active. They don't have to reengage. They're fully engaged. So I look at CXP and I say, look, the pricing signal that comes out of that as far as the cash purchase of a REIT is really unusual because they could do it from an LBO model. As far as individual transactions, I think that the 360 Park Avenue South transaction with Boston Properties is probably a better signal. I can tell you we have been the lead bidder in at least one office sale process, where the sellers decided not to sell. So I think that there are people who are out there who test the market right now. They don't like what they see and they go back away. They still have a thought that they can get a better value in the future or they maybe have decided based on pricing not to move the asset. And my -- but my big view on CXP, very unusual. Low leverage, they're able to lever it up. You had a joint venture partner and they already controlled a lot of the transaction. And you've got somebody who has such a huge pile of dough they looked at it as a 5-year opportunistic play.

Okay. I thought your comments were interesting about office being high CapEx and you sound a little bit more inclined to bite on retail or residential. I mean you own a lot of office. Do you think -- should we expect to see you be paring down your office assets?

Well, look, our goal is to grow the business, not to shrink the business, number one. We certainly have the ability, if we wish, to raise capital at a market rate, which is very, very attractive to sell joint venture interests in our portfolio if we needed to raise capital because we have no -- we don't have one joint venture in our entire portfolio. However, we've got a great balance sheet that's really flexible. I think we'd look to add to, not shrink. And I think that, again, to be clear, our look is what will deliver the best value, the most accretive to our investors in the shortest period of time.

Okay. So it looks like we're -- we have about 1.5 minutes left here. There's so much to talk about with your company, anything that you want to get across that we haven't covered yet?

I think the biggest piece is that we fill a real need in the marketplace, all right? There are lots of bright shiny new building concepts out there, Class A stuff, which is great. That's not what we are. We're fully modernized for the 21st century, energy efficiency and Indoor Environmental Quality leaders with great locations at a great price point. And we've got this fantastic boost with regard to the Observatory whereas that business returns, it flows immediately to the bottom line. With a great balance sheet, we feel super right now, Jamie.

Okay. Great. And then if I could just get one last question in. You had talked about the prebuilt business. We're seeing WeWork kind of get back on its feet. I know you've not been a fan of co-working over the years or not believer in the business model. Are you seeing greater competition from some of these co-working platforms? I know the prices have come down and are probably a lot more competitive than where they were before. How do you think that's going to play out versus your portfolio specifically?

The folks who come to us by virtue of what we have, perhaps, are driven to be in their own spaces. They want to control their own environments. They want to provide an environment to which their employees can come with confidence. One of our largest tenants made the comment to me that out of their worldwide portfolio of offices, we were the most clear -- we are the most clear with regard to protocols, Indoor Environmental Quality and this piece about energy efficiency. I think WeWork to the extent that they provide short-term flexible office space for large tenants that is fully built out, that could be an interesting market for them. As far as the shared workspace environment, boy, I think that's a tough one.

Okay. All right. Tony, always a pleasure to speak with you. We really appreciate you taking the time. And good luck at the conference this week, and we look forward to continuing the dialogue.

Thanks so much for having us. Appreciate it.

Thank you.