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

[Technical Difficulty] 3:40 p.m. Monday session at Citi's 2023 Global Property CEO Conference. I'm Michael Griffin with Citi Research, and we're pleased to have with us Empire State Realty 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 or on the AV desk. For those in the room or on the webcast, you can sign up on to liveqa.com and then go GPC 23to submit any questions if you do not want to raise your hand. Tony, we'll turn it over to you to introduce ESRT and any members of management here with you today, provide any opening remarks, and then we'll get into Q&A.

Terrific. Thank you very much, Griff, appreciate it. I'm accompanied by Christina Chiu, our COO and CFO. COO is a new title. An addition for her, so congratulations Christina. She's a great partner. Glad to have her here with me, our first appearance together. 2022 marked year of notable progress towards ESRT's top 4 priorities: one, lease space with 1.1 million square feet leased in 2022 and meaningful increases in occupancy and lease percentages. 2, sell tickets to our completely reimagined Observatory, which was named the #1 attraction in the United States by TripAdvisor with strong revenue per cap and the potential to reach pre-pandemic levels of NOI in 2023. 3, enhance shareholder value through our capital recycling out of our suburban assets and into multifamily, which is now a fourth leg of ESRT's well-diversified cash flow stream, coupled along with the repurchase of our shares; and 4, the continued leadership in ESG initiatives. We're fortunate to be backed by a strong and flexible balance sheet. In this environment, we feel confident in the company's abilities to execute on our goals and drive growth for our shareholders. To be clear, 260 basis points increase in lease percentage, 210 basis points increase in occupancy in 2020 to that's virtually 90% leased. We also want to be clear that we offer a great outlet in Flight to Quality. Flight to quality is not just new versus old are redeveloped and repurposed existing buildings, compete and win, and that's important. Our energy efficiency and healthy building leadership is recognized by industry government NGOs. We're in the room where it happens on policy development and implementation. Our amenities and our locations lead to the fact that we've had over 2.5 million square feet of tenant expansions since we went public in 2013. So we just want to talk a little bit and focus today on any questions that you've gotten for us and the fact that we're ready to drive value for investors in the future, we've outperformed in the past 2 years plus and will outperform going forward.

Well, thanks for that, Tony. That was very helpful. We're starting off each of these sessions with the same question. What are the top 3 reasons investors should buy ESRT's stock?

We outperform our peers putting points on the board, number one. Number 2, we are future ready to drive value for ESRT shareholders with the hard work already accomplished to modernize our portfolio and leadership in energy efficiency, healthy buildings, and sustainability. And 3, our balance sheet strength. We don't have a penny of floating rate debt. We don't have a maturity until November of 2024, and that's a $78 million mortgage. And then we've got some stuff that begins to turn over in 2025. Those would be our 3 reasons.

Then just touching on more broadly, just with the headwinds facing the office sector currently, you've touched on a number of these points, but how is ESRT differentiated from the competition in terms of portfolio composition, tenant makeup, or any other growth opportunities you might have there?

As we've demonstrated our ability to win in the flight to quality category. We have a great price point for buildings that are well-amenitized, again, modernized not just lobbies and elevator cabs, but the guts have been modernized. 95% of our office spaces and retail spaces have been scraped clean of asbestos, the riser has been fixed. We're in position with energy-efficient windows, with energy efficiency practices where we're truly leaders. So that is a big differentiation for us in flight to quality at a great price point and the demonstration is in the proof with points that we put on the board. We have outperformed our peers with absorption, leased and physical occupancy in 2022, and we've got a nice start to 2023 underway.

Then maybe just on that medium price point, but higher amenity strategy, where we're led to believe in an office world that only the top end of the market is seeing domain. Why does that strategy really work?

The popular narrative is wrong, and that is just that you have to be new to win. Clearly, by the way, when people cite like JLL sweat sites, better absorption in buildings past 2015, built after 2015. Well, those are all new buildings and new buildings which are typically empty when they're completed with a higher absorption rate than buildings that are leased. That said, it's a big misperception only the top end of the market sees demand. Our leasing results speak for themselves. We, at one point, had 1.1 million square feet of leases in 2022 with positive mark-to-market lease spreads in Manhattan in each of the last 4 quarters and expansion of tenants, including iCapital, Signature Bank, Progyny, Crown Castle, and others. We leased just shy of 300,000 square feet of prebuilds during the year, nearly matching the volume in total that we leased in 2019. We've got a very healthy pipeline for '23. So I think it's just wrong to look at things that it's you're either new or you're dead. That's not the case.

Great. That's helpful. Just turning in terms of leasing expectations, what my tenants be asking for today, they might not have been 6 to 12 months ago? And are you seeing a pause from real estate decision makers? Or are more tenants looking to test the waters now?

So we've not seen a notable change in rent concessions, TI packages, or free rent periods over the last 12 months. We have seen higher quality tours with good conversion rates as evidenced by the 1.1 million square feet of leasing we did in 2022, even though we saw a lower number of tours overall. So the tours that we get in 2022 and in '23, these are motivated people. They're not just out there kicking tires, they have a need, and we help fill that need. And the fact of the matter also is that healthy buildings that are modernized and energy efficient, that's what the tenants want. It's what they want and I think everyone should look at that as far as enduring value, not only as investors, but also from what the lenders will think.

And are there any particular industries or tenant types that you're seeing more demand coming from?

We really have quite the blend in our investor deck in. Katy Malonoski and Shaw McGrath are here with books that are available for people as they walk out. We've got a very broad variety in professional services, financial services, technology, nonprofit consumer products. So it's really a very good mix without overemphasis on any one product type.

And then just for the upcoming lease expirations that you might have to backfill. I think it's a more manageable expiration schedule relative to some peers is only about 13% of leases coming due over the next 2 years. But for those leases that are coming up, if there are any large outstanding ones, what should we be thinking about in terms of concessions, TI packages, free rents in order to get deals over the finish line?

So look, we've got 5.1% or 491,000 square feet of space, which will expire in 2023. This was already offset by 320,000 square feet of signed leases expected to commence next year. And then we'll go to work next year, we will have more work to do. We've got pipeline right now active with leases and discussion and negotiation as well as terms for leases to which we hope to get. We don't see any meaningful change in terms. We see our lease cost per year as a percentage of initial rent, about 16.6% was in line with the past 4-year range of 15% to 19%. For free rent, a good rule of thumb is about 1 month free for every year of the lease. When you get up over 10 years, you start to look at 12 months at 10 years. And then the terms, of course, will depend on the length of term. So the reality is on our prebuilds, we do offer some shorter-term leases, a few as short as 3 years, most are in the 5- to 7-year range. And our larger leases where we custom-build, we're still doing deals at 10 years up and more. STV, a 65,000 square foot lease we just announced last week -- or 2 weeks ago, excuse me, we identified the tenant last week at the Empire State Building, moved from 225 Park Avenue South. That's a lease with 15 years of rent payments and over 16 years of rent term.

And Tony, in your discussion with tenants and real estate decision-makers really, really the top end there, is there more a concerted effort for them to get workers back to the office? Do the employers, these employers want their employees back? And any kind of insight you might have on discussions there would be helpful.

Right. So we're much closer midweek now to 60% as far as occupancy in New York City, closer to 80% in the greater New York Metro area, physical occupancy compared to 2019. When you look at Disney, Amazon, consistent themes that we hear from tenants of ours who have not made public statements, so we won't talk about private statements they've made to us is that they want tenants back together for collaboration, creativity, productivity, training mentorship, et cetera. I was rather surprised to learn from one Disney post that ADHD and dyslexia, I have both, should qualify me for perpetual work from home. We don't think that makes any sense, and I don't think those companies do either. So we think companies want employees, though, to come back into buildings where they will be happy to be. So the subjects of energy efficiency, the subjects of healthy buildings, the subject of sustainability, where they can put not just points on the board for their own corporate CSR goals, but also to be able to market to their folks. STV specifically said the reason why they wanted to come to the Empire State Building is because they're a service business. They want people- engineering firm. They want people in the offices. And they want an office that will be a tenant, a tractor, and retainer of talent. So that on top of the fact that people want easy access to mass transit and again, location there really matters. So we think that we won't go back to where it was. We'll have a new normal. I think it will be settled as we get into 2024. I think we'll see a lot more back in the office.

And then maybe let's just turn to ESG for a second. I know you've done a good job highlighting initiatives that ESRT has undertaken. But as we sit here now, can you highlight any specifics on any of those initiatives that you're undertaking that you'd like to sort of expand on?

So look, as I mentioned, we're at the nexus of policy and practice. We're the only New York City commercial landlord, who was on the Department of Buildings Local Law 97 Advisory Implementation Board. We are the only commercial landlord who's on the Mayor's Sustainability Council. I chair the Sustainability Policy Advisory Committee of the Real Estate Roundtable, which is the umbrella-lobbying group for the real estate industry based in Washington, D.C. We have extensive work we have done with the New York State Energy Research Development Authority. Their Empire building program was actually conceived with us, and we carried it out for them. It's work we have to do in our portfolio anyway and at the same time, we got the majority of our costs paid for because what we did is took all the work we did and we published it and made it available for everyone else to be able to learn from. This is consistent with what we've done in our leadership early on with the Empire State Building Version 1.0 that we did with the Clinton Climate Initiative, the Rocky Mountain Institute, and Johnson Controls. We're now on version 2.0, where we fulfill further our goal, our strategy, our mandate, both to develop new technologies and implement new systems and practices, and then share those publicly with people without copyright, without trademark, and without charge. So that we've also made really big headway in waste diversion, construction debris diversion. We've also made significant headway in healthy buildings. We're a green lease platinum leader for the EPA. We haven't allowed volatile organic compounds to be installed in tenant spaces for more than 10 years. We are 100% wind powered. We are carbon neutral. We move now towards more of that to be done, more and more of that to be done as far as the carbon reduction on our property sites as opposed to through the use of REX and offsets. So our thought is, along the way, by the way, take a look at our sustainability report on our website. Our thought is that along the way, investors can get in tune with us whatever they like. It's what the tenants want. And tenants prefer this work, and I think that's one of the reasons -- key reasons behind the fact that we have so many tenants expand with us and that we continue to attract new tenants and outperform the marketplace, particularly when we can do all of this at our price point.

And then just maybe expanding on the E in the ESG. It seems that Local Law 97 in New York has continued to come up from focus. How can Empire benefit from changes in regulatory requirements from this? I know it's a continued point of focus, but any commentary there would be helpful.

Well, our commitment to our tenants is to minimize the prospect of any find to have to be paid through the implementation of this law. And that's where we are actually in the work that we've accomplished. We'll have no fine to pay in 2024, and we've got our clear pathways for the 2030 and 2035 standards. We also are in the room where it happens with regard to how policy is established, and we help inform policymakers with our actual practice. Therefore, we're in a great opportunity to take advantage of such things as the tax credits for on-site energy storage or generation and other energy efficiency improvements. All of which was located in the Inflation Reduction Act, which is actually language for those tax credits that we got put into the bill through Joe Manson's office through my leadership on the Sustainability Policy Advisory Committee of the Real Estate Roundtable. So we're actually able to sit down and talk with people about science-based targets. We have been certified to the highest level of science-based targets initiatives so the 1.5-degree climate change objective to reduce it to -- or to minimize it to 1.5 degrees. We are absolute leaders. Our GRESB scores are the highest in our peer group and we take the S quite seriously as well. We're the second year in the gender equality index for Bloomberg. We are certified one of the great places to work and we're just engaged on all levels on these intangibles that help separate, frankly, from how other companies perform along with our balance sheet at our price point with our amenitized buildings. We're just extremely competitive.

Let's switch over to the observatory for a bit. It seems like demand returning here with NOI more or less expected to be back at pre-COVID levels. What are you seeing on the ground in terms of visitorship interest? And are you doing anything either pushing price or raining in expenses that's allowing for more of this NOI recapture?

Right. Well, we are the #1 attraction according to TripAdvisor in the United States, #3 in the world behind the Coliseum in Rome and the Sagrada Familia in Barcelona. We must be doing something right. We spent $165 million to completely redo the experience, build on the authenticity of the Empire State Building. In order to get to what we put together there, we interviewed thousands of people from ages 5 to 75 and 12 cultures and 9 languages. So we basically turned around and fed back to people what they already had in their expectations with regard to our experience. And then we took it during COVID, and while we were shut down, redid our program, made it reservations only. And to go to reservation only was a big shift. What it also enabled us to do is to control our points of access to get rid of crowds, which previously we could not control to give everyone a better experience. We reduced the number of people who are available who are allowed to go up to the 86th floor observatory during sunset, and we skew that towards our retail customer, and we reduced the number of slots available for past and online travel agent programs. We've increased our prices, and we greatly decreased our discounts and because we know when people come through, we know when the demand is ahead of time and we staff accordingly. So we've been able to recover significantly, not just from the highest per caps we've ever experienced on this revenue mix as far as how people come in, either retail, pass program, or online travel agents. Also, we've reduced our hours worked. And then on top of all of that, all of our people, I don't care if they work in the observatory if they work in buildings, whether they're in [Technical Difficulty] and most of our people are the Observatory, all of our people to the observatory except for our supervisors or union. Same in our buildings. They all get trained. We've got Ritz-Carlton, who does an annual training for all of our people. We've got a hospitality approach to how we handle people. We think that kicks into what we get from tourists for incredibly high marks on their experience as well as, of course, our tenants. We got the people they touch get the same training.

That's very helpful. And just to piggyback on that for a sec. What worry is there, if any, about competing observatory decks and then what might that do for demand for ESB?

I love this question because when we did our roadshow in late September, early October of 2013, people assured me that One World Trade Center was going to kill us. It didn't superbly doing 1 million people, and then it was the edge. No, it didn't bright shiny penny. It's already on the decline than it was the summit. Again, Bright shiny penny, it's already peaked. In the meantime, we continue to be the unique, the authentic, the true New York experience and the revenues, the visitorship, and the ratings, I think speak for themselves. And we will continue to maintain that quality of experience. There's only one Empire State Building, and then there's a lot of other tall stuff.

Maybe just switching over to the street retail portion of the business. Have you noticed any incremental demand from this and just given the expectations that fundamentals have sort of bottomed the recovery is expected there? And then just on your occupancy upside for expectations, is there any of that from the street retail baked in?

So 93% of our retail revenue comes from national brands. We've got Target, Sephora, Foot Locker, Urban Outfitters -- when you look at what we actually do, we provide very, very, very, very few super luxury experiences. The one exception might be the new 23,000 square foot 3-level Starbucks Reserve that just opened at the Empire State Building. So when we look at that, we feel pretty comfortable. We see in the market, Griff, is increased demand, and the tenants are back. They are back at 40% to 45% lower rents. That's a fact. So we actually look at this from a perspective of: A, we can lease; B, we'll actually even look along when we look at acquisitions at additional locations in retail. They just have to be priced accordingly because the rents have come down and at the right rents for retail in New York City right now, things lease.

And then just maybe on the multifamily platform, if I could, the continued expansion there with the recent acquisition at Mulberry, fundamentals might be a bit more favorable for residential compared to office overall. But just how should we think about this in the context of the overall portfolio? You talked about being a New York City-focused landlord. So where does that fit into the piece of the pie? And don't worry, you don't have to give a specific number.

Okay. Thanks. Look, we're omnivorous opportunivores. Where we see opportunity, we want to take advantage of that. We saw an opportunity in residential. We want to focus on accretive cash flow. That's the point. FFO is not as attractive to us as AFFO at this particular point in time. So some of the revenue -- or excuse me, cash that we had to buy those residential properties actually came from properties we traded out of mature retail on Main Street in Westport, Connecticut, some suburban office properties, very effective from a tax perspective, 1031 exchanges and going into assets which were immediately cash accretive. 298 Mulberry was pretty straightforward to us. It was a failed sales process, 100% free market units at a fantastic location in the East Village, sort of NYU Central, an extraordinarily high percentage of that, a little over 2/3, is co-signed and very high population of women at that location. The owner of the property didn't realize that but we just need to cater to that specific population and to do a better job, and we see tremendous upside in that asset. We'll continue to look at multifamily. Then again, though, we'll look at all the different food groups. It's just that office has to get to a loan off basis where we can spend the money that needs to be spent in order to make it energy-efficient, truly modernized, amenitized, indoor environmental quality, and indoor healthy buildings. And we need to be able to account for the fact that there'll be an interruption between the time we invest the capital and the time we start to get cash flow out of that. It's got to be worth the effort. I don't know, Christina, if there's anything you want to add on the acquisition side?

I don't know. That covers it.

Great. Thanks. Tony, I'd love to get your thoughts on just what's going on in the market in terms of continued opportunities in office to resi conversions. I don't know if it makes sense for maybe any assets in your portfolio, but it's certainly coming up a lot more with investors that we talk about. Does the basis in the building? Does it have to just be low enough for it to make sense? And do you think that it's feasible that a lot of this older office stock that's out there generally in the market could be converted to some other use?

So we've actually spent a fair amount of time and study on this. It's the second wave, if you will. The first wave was downtown buildings, which were converted. What we have deduced is, first of all, it's doable. Second of all, you don't end up with ideal floor plates. Third of all, you have a real systems challenge. If you look at some of these office buildings, which were converted to resi, they have extraordinarily high utility costs because the systems weren't installed correctly. The residents pay very high utility costs. A number of these buildings or what's known as within the leasing community of residential brokers as sweater buildings. It's not because you sweat all the time in the winter, you have to wear a sweater. And in the summer, it's warm because the units are undersized and you can actually get your apartment hot or cold. So we think that there is potential here. Every single bedroom in New York City requires a window, right? So when you look at some of these conversions and you look at what the prospects are, it doesn't mean it can't be done. It just means that on a per square foot basis, you may end up with bigger units because the floor plans don't lay out correctly, you may end up with some rather circuitous hallways. We man up with a bunch of interior space, but that's also an opportunity to increase and enhance amenities. I think there's an economic model for it. We don't think it gets the same rent, the same desirability as purpose-built residential.

To that end, do you think that Midtown could become a viable mixed-use submarket out there? Obviously, we know about Governor Hochul and Mayor Adams' new York initiative. But as I think about as you alluded to, lower Manhattan in a post-9/11 world kind of converting to a more mixed-use residential component. I live in Lower Manhattan and I can attest it's a great place to live. But any thoughts around Midtown being viable from that standpoint?

It really depends on the building. There have been efforts made. There are efforts underway right now on certain assets to underwrite them for resi conversion on Third Avenue and some other locations. Again, I think it's all just a matter of -- I think there are enough food stores and there are enough general services available. You may have a slight issue as far as schools -- and I think, frankly, that Midtown with its transportation hubs, extraordinarily well configured for office. Does that mean that you can't do resi? Well, if you've got a building that's largely vacant or can be vacated or where you can put all of the office up top of the resi down below New York City zoning is a little interesting that way. There are different ways to look at how you've got to put risers. I mean typical residential has electric, plumbing, waste lines going vertically to every building, what can you accomplish horizontally so that you don't have to do all those penetrations. I think there's a chance. It's one of these things where I think everything is logical based upon what your all-in cost is and therefore, it depends on what your basis is. Either way, though, I think on a bunch of these unimproved assets, which aren't modernized and are not energy efficient, have not had the investment put in them. And again, they will probably suffer as far as value is concerned. They're not competitive as office. They won't be competitive as resi without a major investment, and that means your starting point has got to be low.

Maybe we can just touch on capital allocation and external growth opportunities that they're out there. What, if anything, might make sense right now? Is it acquisitions if they're out there? Is it buying back stock? And I'd just be curious to get your thoughts, just given where office REITs in general trade at a discount relative to their NAV. Like do you think that NAV is a good metric that we should be looking at in terms of valuation?

I'm going to hand this over to my partner, Christina Chiu.

Outstanding.

So on capital allocation, we've been very clear we are interested in share buybacks. It's a strategic part of our capital allocation. To date, we've done over $280 million since the program began in March 2020. And took place in 2022. As we head into an uncertain environment, we will watch out for pacing. The stock is definitely discounted. But operating runway, having cash flow, having flexibility is extremely important. So we'll balance that also against opportunities within the portfolio. We've mentioned interest and continued efforts on capital recycling. So we've executed on some of that. As Tony mentioned, I think on the path forward, right now, it's a very uncertain lending market. So it's not really a lack of appetite to sell or even a lack of interest to buy, it's really whether the buyers can secure financing to close on an acquisition. So we have to monitor for that. But capital recycling is still on the agenda. And as we put dollars to work, we will look at New York City office, retail and multifamily with a key emphasis on entry price point and basis and ultimately what the cash flow growth will look like. On your question on whether NAV makes sense, I think the million-dollar question is really what our cap rates and that sort of moves around based on financing, and that seems to be extremely volatile as well. It's also the access to capital, how lenders underwrite they're using criteria that's very different from today's cap rates or yesterday's cap rate environment, in terms of debt yield requirements, debt service coverage ratio. So when we look at deals, certainly, we'll look at the cash flow yields provided by the assets. But I think incredibly important to look at all-in basis. That includes your buying in basis, whether that's on a debt per square foot value, whether that's on resi conversion, when you're looking at what you get in at and then the cost to reposition the asset, add amenities if that's relevant, the downtime associated with leasing, TIs associated with leasing, pull it all together and triangulate back to, is that a logical per square foot number relative to the neighborhood and type of asset that I'm buying. And that's the kind of criteria that we look for. And anything that we look for, we really look to be additive to the portfolio. So take retail, for example, if we have very strong everyday retail, we have 2 targets in the portfolio, the 3-floor Starbucks, the 4 at Foot Locker, we're going to be very selective on what we add incrementally to see whether it adds volume.

The only thing I'd add to Christina's comment is we did all of those share repurchases is an average of $8.34 a share. So we held back in spite of a lot of climber, including from your former head of this particular group that hosts this little get together Mr. Bilerman, and we were logical to do it, and we got a much better value for our shareholders in the process.

Well, Mr. Bilerman is a great guy, so I want that on the record but he's certainly a firecracker. Maybe we can just talk on CMBS market and the implications. I know it doesn't affect your properties in general. But any thoughts on what that might do to office sentiment we see in the news about defaults and lenders potentially handing back keys?

Yes. I think, well, that markets are not functioning very well. It's both expensive as well as using criteria that doesn't really work at yesterday's valuations. And the last piece is floating rate debt. So starting with the CMBS, I think there was a recent industrial deal where even the A-tranche price at SOFR, just inside of 200, I think SOFR plus 170, right? If we're doing the math, that brings you into 6%, and that's on a favorite asset class, so we can barbell from there. That doesn't mean that the permanent and new cost of capital, that means that's what it took to get CMBS across the finish line at that size, at that particular point in time. Blended criteria, I already alluded to, has shifted. So that has really moved. So I think that will all impact pricing. What you're seeing now is just the beginning of office defaults and some of that is maturity where they need to come up with more equity in order for the deal to work, and they have to decide, do I put new equity after old equity and is that good equity after bad equity? So that's some of it. Some of it is interest rate hedges have become prohibitively expensive. So a common form of loan over the last couple of years has been short-term LIBOR, SOFR floaters, where owners should have been sellers, but instead they kick the can down the road, and they hope to use that capital, lease up the asset, and hope for a positive CMBS execution. We just discussed that CMBS execution is off the table. And now if you get another short-term line, you have to pay for the interest rate caps, and that's just another form of equity. So again, we're back at the table. So it's not surprising that you're seeing some of it. For us, we don't have floating rate exposure. We don't have that maturity pressure. We will look to the market and be very selective on whether any of these actually become attractive opportunities.

We've got my rapid fire to finish up. Best real estate decision today: buy, sell, develop, redevelop or pause?

Buy either assets or shares an appropriate values.

Same-store growth for 2024 for office?

In general, down, up for us.

More, fewer, or the same number of office REITs a year from now?

It should be fewer. There are some CEOs out there who think their assets are better than ours and do not want to lower themselves to transact with us. Of course, we've outperformed them.

And Tony, I have one more fun one for you. Any chance we can get you to light up the ESB in Red and Black when the Georgia Bulldogs run it back to complete their 3-peat this year.

We did it once, we'll do it again if they win.

Love to hear that. Thanks so much.

Thank you.