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

Welcome to the 8:50 a.m. session of Citi's 2024 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. Disclosures are available on the webcast and at the AB desk. For those in the room or the webcast, you can go to liveqa.com, and enter code GPC24 to submit any questions if you do not want to raise your hand. Tony, we'll turn it over to you to introduce ESRT and the team, provide any opening remarks, and then we'll get into Q&A.

Super, and I will just let you know that shortly, I will be joined by a female voice who is our newly appointed President, Christina Chiu, who had to stop by an essential place on her way from our last meeting. So thank you, Citi, for the opportunity to present and to those here physically and electronically, I'm Tony Malkin, Chairman and CEO of ESRT. Christina Chiu will join me shortly. In 2023, we continue to put points on the board in line with our 4 priorities: to lease space with nearly 1 million square feet leased, meaningful increases in occupancy and lease rates in 2023 and further gains as expected as outlined in our 2024 guidance, sell tickets to our Observatory, which was named the #1 attraction in the United States by Tripadvisor for the second year in a row and saw NOI return to pre-pandemic levels in 2023. Three, achieve our sustainability goals for energy efficiency, indoor environmental quality and continued leadership and sustainability initiatives; and four, maintain our best-in-class balance sheet, which is a big differentiator to tenants and brokers in this environment and positions us to allocate capital as we think best for our investors, be it capital recycling, new acquisitions or share repurchases. ESRT is the pure-play New York City REIT, and we have 4 diverse ways in which to play it: an office portfolio that is top of our tier and targets the deepest market segment; our top-ranked Observatory; our high foot traffic everyday street retail; and a growing multifamily platform. Remember, our NOI is derived 60% office, 25% Observatory, 10% retail and 5% are in our growing residential and the 40% that is not office, throws a lot more to the bottom line than office does. We have maintained a strong and flexible balance sheet, and that is a major differentiator in this environment and ensures our ability to execute on our goals and drive further value and growth for shareholders in 2024. So Griff, happy to take any questions you'd like. Thanks again for being here. Folks online, Christina has joined.

Thank you very much, Tony. We're starting off each of these roundtables with the same opening question, what are the top reasons investors should buy ESRT stock today?

Number one, we're the only pure-play New York City REIT that benefits from 4 diverse drivers of demand: office, retail, multifamily and tourism in the greatest city of Earth. And that -- just remember, our NOI composition, the diversity in that is great. It plays to New York City, it plays to strength. Two, balance sheet strength allow us to execute win new tenants, take advantage of opportunities created through market disruption. Three, market-ready portfolio, future-ready portfolio. We see it in our leasing. We see it in our positive absorption. Four, proven track record of leasing results. When you look at nearly 1 million square feet leased in 2023, 8 consecutive quarters of positive lease percentage absorption, 10 consecutive quarters of positive mark-to-market lease spreads for Manhattan office over 2.6 million square feet of tenant expansions in our portfolio since the IPO. And perhaps the most important, number five, we are on our front foot. We're in a position to take advantage of this once in a 15-year cycle to act while at the same time to deliver our portfolio where we've already invested $1 billion in modernization, not just lobbies and elevators, but scraped 92% of our available office area coming of our total office area clean, new asbestos, new hot water, cold water, waste water risers, electric distribution, energy efficiency, indoor environmental quality, and that's why we're killing it in leasing right now.

And Tony, with the headwinds facing the office macro environment broadly, how is ESRT differentiated from the competition in terms of portfolio composition, tenant makeup or any other growth opportunities?

New York City is a great market, and that differentiates us from anyone who is not in New York City. Number two, we have a unique value proposition. We are top of tier. We serve the deepest component of the market with fully modernized, energy-efficient, amenitized buildings in great locations. And service distinguishes us to our tenants and to the brokerage community. And then on our front foot, we have this opportunity because of the unique intellectual property we had where we have renovated and gutted and redone all our buildings. We know how to do it. We know what it takes. We know how to bid it out and we know the time it takes to release it once we get it done and at what prices we can, with the best-in-class balance sheet. All that together, we provide a flight to quality. And as people realize now, I said it a year ago right here, the narrative was wrong. Now people understand it's not just AAA brand new buildings, which will experience positive absorption. We had over 700 basis points positive lease percentage absorption at 1359 Broadway and the Empire State Building alone in our portfolio. So again, we demonstrate and deliver points on the board quarter after quarter.

And Tony, -- why do you think the demand for the medium price point that highly amenitized product is more attractive to prospective tenants relative to newer buildings that command higher rents in New York?

Yes, so -- we think that the price point is extremely attractive because of everything that we offer. There was a common narrative, very pervasive last year that said $200 price point product is new, shiny, looks great and everything else will be in trouble. And we sought to prove the point that if you have competitive product that is amenitized, is modernized, has modern HVAC, energy efficiency, you can provide services and the full package, but you can do it at a price point of high 50s to high 60s in our Broadway campus and 70 to 80s at Empire State Building and One Grand Central Place, that is a huge value proposition. And the work that we have done on the portfolio, the $1 billion of CapEx that we've invested to be fully ready to go has translated into our portfolio being 92% leased. So I think tenants, the common link is not everyone is in the market for $200 space. Everyone is in the market for the best possible space that they can get for their money, and you're seeing that translate in leasing results.

Maybe we can just touch on leasing for a bit. Can you give us a sense of what you're expecting in terms of leasing volumes through 2024? And are real estate decision-makers shortening their time when it comes to making leasing decisions?

So first, I'd just like to say, January was the highest number of tour visits in any month since 2019. February, only 29 days was right up there. So we've already concluded 125,000 square feet of long-term leases signed after 12/31/23. 16,000 -- excuse me, 16-year 68,000 square feet expansion lease with Burlington at 1400 Broadway; 57,000 square feet new lease was Sol de Janeiro, L'Occitane subsidiary at One Grand Central Place. L'Occitane is a tenant of ours at 111 West 34th Street. They just expanded at 111 West -- 33rd Street, excuse me, not 34th Street. And they are about to expand again at 111 West 33rd Street, taking on an option that they took when they did their last expansion. By the way, a humorous anecdote. I almost didn't do the L'Occitane lease because I insisted on the French parent guarantee of the lease. Our leasing people didn't really enjoy that thought. We did get the French parent guarantee during COVID, their U.S. piece was thrown into bankruptcy. We kept the tenant, now they've grown with us. So in addition, we have 30 leases in negotiation right now on about 200,000 square feet for new renewal relocations and early extensions, including pre-builts and full floors, a few hundred thousand square feet of active proposals. So very good activity. And the market itself is at least flat at this point, but we are truly outperforming the market.

And Tony, can you give us a sense -- you talked about the highest tour numbers since 2019. Of those tours, how many prospective tenants are likely to convert to a lease?

Tenants who come to us on towards really since COVID have been tenants who are [indiscernible] leases. And tenants who come to us specifically are typically tenants who want to move from where they are presently. We are a flight-to-quality destination. We are a different product. So is this not a commodity visit? It's a question of, in the case of super top quality tenants, do they wish to downgrade to our top of tier in a lower price range? And that's what it is. And we've been able to convert a number of them. Because they realize, "Wow, I get all of this at a better price point". Are people prepared to upgrade to our higher price point? And are people already paying the price where we are and what we want and just say, "I can get a better product for that". So let's be clear. People don't go out idly shopping today. They go out with a purpose, number one; and number two, -- when they come to look at us, they know they are looking at a differentiated product. So therefore, it really comes down to, will they come to our locations.

We had a question come in through the live QA feed. Can you give any update as it relates from the fallout of New York Community Bank? Is there any potential impact to Flagstar given that they assume the leases from Signature Bank last year?

Sure. So as a recap, Flagstar is a little over 300,000 square feet at 1400 Broadway. That's our best lease building, 100% occupied currently. We have a few leases up for expiry and already spoken for us. So a very strong building, well amenitized, well located, the full package. In context, the Flagstar lease is 2.5% of ESRT's total revenues. So just for sizing, big headline, but it's 2.5% that we're talking about. We stay in touch with the tenant, we remain close. We don't know more about their specific situation than what everyone is reading in the papers, but we remain close and engage with them. and it's business as usual from a day-to-day perspective. In terms of what we can do, what's within our control? We are very proactively looking at alternative options for the space as we plan for contingency. And within that, those are very attractive floor plans. We have a combination of contiguous floors and separate floors. So offers us a lot of options for leasing, and it finally gives us something that we can potentially offer to tenants, which is also good in a well-leased building. In terms of pricing, Flagstar is currently in at just under $60. So there is a mark-to-market opportunity in terms of rent. If you look at our last lease that we announced in the building, Burlington for just under 70,000 square feet, that was signed close to mid-60s. So there is a mark-to-market opportunity. So overall, as always, we will be a very proactive, closely monitor and be in a very good position to backfill the space if we need to do so.

So I think what's really important to note, look, there's no question we were happy to maintain the tendency when Signature was taken over. And there is no question we would be happier to have Flagstar survive. That said, we have 1 floor in our New York City portfolio available for direct lease right now. That's how good our leasing has been. So when you look at the total size of the portfolio, 92% plus leased and you look at 8% vacancy, we have about 720,000 square feet to lease right now based on our vacancy. And we have some roll in 2024, we've got most of that covered already. So again, as we have said in our guidance, we anticipate further leased percentage gains in 2024. And so we do have demand for this space. If we had a choice, we'd love to keep them. And if not, we think there'll be demand and we can probably get a positive mark.

Maybe we can talk about the 2024 leasing pipeline for a bit. Can you remind us if there are any large notable leases coming due? And if so, how are those renewal conversations going?

Sure. no large leases coming due. All in all, we have just under 600,000 square feet of expiries and 320,000 is already expected for renewals and relocation or new leases. That does include the 125,000 square feet of leases. We already announced for the start of 2024. So we feel really good between the pipeline Tony mentioned earlier and the progress we've made that we'll be able to backfill the space, anything that comes available and also reach our occupancy guidance, which, as a reminder, is 87% to 89% for the year.

And how have you noticed concessions, both tenant improvement dollars and free rent been trending this year? And how do you expect them to trend over the next few years?

Yes. So concessions have largely stabilized. We've been saying this for 12 to 18 months. They haven't gone away, but they haven't gotten worse either. So very rough rule of thumb, about 1 month of free rent per year of lease and on TI contributions about $120 per square foot. When you look at this data across different leases and data points, the important thing is to look for the quality of the lease, quality of the tenant and whether you're getting term. $120 spread over 11 years is very different from $120 spread over 5 years. And so that's where we spend a lot of time, which is doing our part to offer a lot for the tenant and on the other side, making sure we're striking economic leases that are attractive with high-quality tenants and terms. In terms of where concessions will go, this seems to be where market is, as we continue to be able to lease up space, drive lease percentage, we look to improve on economics. But for now, it's stabilized at these levels.

Maybe turning next to street retail. What's your sense of demand for these properties? And is there any incremental occupancy from street retail baked into your occupancy assumptions for '24?

Well, let's break that into 2. Number one, there is no question that at the right price, there -- and with the right locations, retail is back -- physical retail is back. New concepts, yes, some older concepts. And the bloom is largely off the roads from years back conversation about online home delivery changed the world forever. It was in this room several years ago that I said if you look at the percentage of catalog sales to retail sales, and look at catalog sales at that time plus online to retail sales in bricks and mortar. There hadn't been that big a growth -- there's some growth, but not that big a growth in the online catalog combo versus just catalog in prior years versus bricks and mortar. That said, removal of free delivery for shipping a lot of online and direct-to-consumer retail efforts beginning to fail or have failed already. So that's a plus. That said, we do see some demand, and we do see some -- we see basically with the return to our CBD locations of workers, people want to be there to service them. As far as what's in our guidance, Christina, what do we have?

For retail -- we don't give specific retail occupancy, but it's 90% occupied and it's currently 92% lease, both those figures fit into our overall occupancy guidance of 87% to 89%.

Next, maybe shifting to the Observatory. With NOI expected to be above pre-pandemic levels in 2024, how much room is there to run in terms of growing this part of the business? Will it be mainly through maximizing revenue or controlling expenses or some of them?

Well, first of all, let's just remember that you're talking about the #1 rated best of the best Tripadvisor attraction in the United States for 2 years in a row. We never thought we'd get it once. We didn't even know the award existed, to be quite candid with you. We certainly never thought we'd get it twice. And I have said to our staff, both union and salaried that they can throw pies at my face if we get it a third time. That said, we like the business a lot. We've gone to entirely reservations only. We control our flows. We charge a higher price. We give lower discounts to our tour and travel online travel agent and past program partners. And people likely experience more than ever based on the ratings and the fact that we give them a better quality experience. We continued to see increased visitorship on the top of higher prices and lower discounts. So we like that mix, and we think we see that people have asked in our one-on-ones in our cubicle, whether or not people think -- should think that we will see back to 4 million people in a day -- excuse me, 4 million people in a year visiting, and we just don't think that's realistic. We have limited the number of people in the park. We have limited the number of people at different times of day. At sunset, we basically have half of the decks available for viewing because everybody wants to be on one side of the building. That got horrendous reviews when we didn't control the number of people in the park at the time. So we do think that there's more room. At the same time, we can create more room by adding more hours. And we know we need to add more hours of reservations, fill up the hours for which we have openings. But I wouldn't expect that we'll get back to 4 million, we certainly think we'll see continued growth.

And Tony, is there a worry, if any, that competing observatory decks could impact demand for ESB?

No.

All righty. You've talked about being a New York focused REIT, be it office, retail, multifamily or the observatory. Why does this diversified strategy work, given that many investors prefer pure-play options when looking at REITs?

Yes. So we are a diversified New York City play. For us, when we added multifamily, the logic went something along the lines of we already own office, the Observatory on top and the retail at the bottom. So already, we were not pure play. When you look at the fabric of New York City and the various sources of tenant demand, office demand, there's shopping demand, and there's also tourism demand. And it seemed to make a lot of sense for us to add residential demand into that mix for a vibrant city like Manhattan and overall New York City. So that set off along with having good pricing at the time that we transacted to add multifamily into the portfolio at the end of 2021. So with that, we have 4 components. And as Tony mentioned earlier, it's well balanced. It's about 60% of net operating income contribution from office, which, as a reminder, has already been invested in, ready to go, 92% leased. We have retail and for us, that's everyday retail, high foot traffic. Very pleased with that. That's about 10% of the portfolio. Multifamily is about 5% and Observatory is 25%. The concept of the REIT investors like pure play is a bit antiquated when you consider -- look across the landscape, very few are actually pure play. SL Green does a variety of things. Vornado does a variety of things. PGRE is an office, but they also have different markets, including St. Fran. When you go down, JBG is looking for multifamily. You go on the West Coast. You also have Douglas Emmett that also does multifamily of HBP at the studios. You get the gist. Very few pure play, it's pure-playing concept, but the reality is companies tend to expand and do other things based on what's good for their portfolios and the opportunity set, and that's what we look to do. We won't be random. We won't keep adding. But with these 4 foot groups, we think we are an excellent play for New York City.

And I would just add to that, that when we look at pure play, we do think of ourselves as pure and focus on what we think can deliver long-term value. So we don't look to chase the bright shiny penny. Don't expect us to do any medical research facilities. When that came out, it was hot, we looked at it, we said, we focus on what are the drivers of occupancy. You said, okay, a lot of venture private equity fund companies that don't make money. We've seen that play in tech, doesn't make sense. Special purpose buildings with multi-hundred dollar TIs doesn't make sense. Studios, we looked at it and said, big demand driver is the growth of streaming. We don't see that long term, probably end up with an oversupply situation. We are really fortunate, as I like to say that, my family didn't stop in Cleveland or Cincinnati. Instead, the good news is, we were so broke, we only made it to New York. And the bottom line is, it's the best market in the world. And we're very fortunate to be there, and we have to choose our targets. And we like what we have.

I want to add one more point is we are a New York City focused. We have these groups, but it's not really just about having multiple groups and saying, you're diversified. We look at the resiliency of the cash flow, right? So to have office, which is more CapEx intensive, but as a trade-off offers long-term contractual leases and if structure rate can be very beneficial. You have multifamily, which is generally 1-year leases, a little more closely tied to inflation and different CapEx profile. You have the Observatory, which has much higher margins, no CapEx, not subject to leases, however, offers dynamic pricing and a closer link to inflation, and we can control expenses very well and then retail runs somewhere in between those traits. So what you want is to build a portfolio that has characteristics of zig and zag and can outperform depending on the market cycle. And we think what we've created is pretty resilient.

And I'll say one more thing. We are [indiscernible]. So where we think there is value, that's where we'll go.

Maybe shifting gears to external growth opportunities. Obviously, you've done a good job redeveloping the existing portfolio, but given the capital markets dislocation out there in the distress, it seems like there might be potential opportunities in New York. Have you started seeing distressed opportunities? And if so, how best do you think you could capitalize on these potential opportunities?

Yes. So the investment market is still pretty light in terms of available opportunities. Capital markets are certainly dislocated and you would think there would be more. But a lot of what's going on and this pervasive is a lot of kick the can down the road, extend and pretend. A lot of loans remain on bank balance sheets and other holders. They continue to work with existing operators. One, they don't want to take over the asset. Even after you take over the asset, there's no sale market no financing. In addition, even after you take over, there's more capital required to get the assets to where it needs to be, to be able to compete in today's market. So for a lot of those reasons, there's almost a suspended reality. The market was probably closer to seeing some more last year, and then [indiscernible] forward announced a few rate cuts and I think that pulled some capitulation off the market. So we are where we are today. It does seem like between the volume of debt maturities and the continued extend and pretend that something should come to a head, and we should eventually see it. To quantify what those debt maturities are last year, when you look at '23, '24 and '25 maturities, the total was $2 trillion coming due. Fast forward, 2023 is behind us. When you look at '24, '25, '26, '24 has now grown and the same $2 trillion of maturities because of this kick the can down the road. So we see opportunities ahead. And when we think about it, really it requires a real basis reset. We will be patient, prudent look for the types of assets that we want to own, and we believe we can apply our operational expertise, our experience from having redeveloped 9 million square feet within our portfolio to create competitive product and create attractive returns.

And then in terms of any future dispositions, would you expect these to come mainly from the Greater New York portfolio and look to reinvest the proceeds into your Manhattan properties?

Yes. So for the past 18, 24 months, what we've done is capital recycling, exactly accurate, right, selling out of Greater New York and reinvesting into multifamily. So in the future, what we have is noncore sales. We've mentioned Stamford, Connecticut, our last 2 assets, could be within that category. The main issue today is that the capital markets are a bit dislocated, so we'll see what happens there.

And then just on the balance sheet, Christina, you obviously have a relatively strong balance sheet with limited debt maturities, a favorable leverage profile. If the right opportunity came along, could you look to increase leverage? And at what level in terms of net debt-to-EBITDA, do you think you'd be comfortable with?

Yes, our current net debt-to-EBITDA is 5.4%, slower relative to peers. We have room to lever up. We're not looking to lever up in and of itself. Also not looking for a specific target. What we think about is continued access to capital and ensuring that we have operating runway and maintain a very flexible balance sheet. That does mean we can take advantage of opportunities, but we'll always look for maintaining flexibility.

Maybe just switching to quality of life issues. Obviously, I live in New York, I've seen it rebound substantially from kind of the lows of the pandemic. But Tony, when you're talking with key public stakeholders, what is really important in terms of driving confidence to get people back into the areas like Midtown and make them feel safer?

Let's be really straight and get right to the point, okay? People are back and more people will be back just based on the leases we have signed and the increase we have seen in the occupancy of our assets, number one. Number two, I grew up in New York in the late '70s and the '80s. There wasn't a single subway car that wasn't covered with graffiti, including the windows. I would board the cars between the cars in order to get to a car that had air conditioning. We're not in that world, number one. Number two, crime is actually down. Number three, we have a fundamental issue based in Washington, D.C. about immigration. And number four, we've already begun to see roll back in a lot of places of some of the very liberal policies which have caused issues in quality of life, [ organize ] re-criminalize drugs. We see these changes. I feel very confident in the future of New York City. And people are already voted and they will continue to vote with their feet and back to work.

And then maybe just on the topic of office to residential conversions. Obviously, you talked about your portfolio being highly leased, but for supply overall in New York, it does remain elevated. What do you think needs to get done either at the local or the state level in order to incentivize some of these conversion opportunities?

It's all about basis. The basis has to get low enough to account for the fact that, number one, these things are expensive. And number two, when they rent, they rent for less because the floor plates are goofy. Every bedroom requires a window. The utilities are much higher on a per unit basis because of the HVAC, we call them sweater buildings. In the summer, it's too hot. In the winter, it's too cold. And that's with your heater or your air conditioning running full time. So it's all about basis. Basis has to be driven low, and that means to the extent that subsidies can be generated or tax benefits that will help.

ESG is obviously a very important focus for a lot of investors. And something that ESRT pays great attention to. Can you highlight some ESG initiatives that you've currently been working on?

First of all, let's be clear. Our sustainability leadership gets us leases with the best companies and helps us box above our weight. That's proven by how people come to us, what they say when they come to us. We have over 80 tenants who partner annually with our Director of Sustainability to help fill out their corporate sustainability reports. So it is a moneymaker for us. That's our view. That's how we look at it, number one. Number two, the level of sustainability with which we work is metrics, details, facts, not by cracks, not showers, not water features, not green walls of plants. It's actual reduction in occupancy costs due to energy savings. During the Canadian wildfires, the air inside our buildings was as clean as when wildfires were not there because of the work that we put in to keep the air clean going back to the SARS virus. So these factors, energy efficiency, indoor environmental quality, these are the things which move the needle and which the tenants really want. We're pleased to be recognized as one of Newsweek's most responsible companies. We are awarded the Governance Intelligence's 2023 Governance Award for Best Small Cap Proxy. We were the #1 rated company by GRESB in our category in the last report. Not top 5, top 6, not best for disclosure grade A. We're #1. There's only room for #1, and that's where we are on sustainability, and it makes us money.

We had a question come in from live QA here. Would you give any thoughts to adding co-working spaces within your portfolio?

No.

Why?

Anybody -- has looked at this, you can Google my comments on WeWork. We don't believe in it. We believe it's disintermediation between the landlord and the tenant. That's the relationship we want. We think it's a mismatch of obligation versus revenue stream. And frankly, we have our prebuilt programs, and we can offer you a prebuilt space all the way down to 2,500 square feet, but we don't have that many that are that small. We can offer it to you with furniture. We can offer to you with furniture prewired for data. We'll even do the move for you. We just price it all into your lease. Nobody else has that kind of turnkey solution, which we offer and again, it gets us tenants. We don't see the need to bring someone in from the outside to do our business. And we've benefited, and our shareholders benefit from the fact that we didn't do it.

Well, if there are no other questions from the audience, I have my 3 rapid fires to end the session. What is the best real estate decision today, buy, sell, develop, redevelop or pause?

Buy at the right prices.

What do you expect same-store growth for 2025 for the office sector overall to be?

Up.

And lastly, will there be more, fewer or the same number of publicly traded office REITs a year from now?

Fewer.

Great. Thank you so much.

Thank you, Griff.