Empire State Realty OP, L.P. Q2 FY2020 Earnings Call

Greetings and welcome to the Empire State Realty Trust Second Quarter 2020 Earnings Call. As a reminder, this conference is being recorded.

Good afternoon. Thank you for joining us today for Empire State Realty Trust's Second Quarter 2020 Earnings Conference Call. In addition to the press release distributed yesterday, a quarterly supplemental package with further detail on our results and our latest investor presentation were posted in the Investors section of the company's website at empirestaterealtytrust.com. On today's call, management's prepared remarks and answers to your questions may contain forward-looking statements as defined in applicable securities laws, including those related to market conditions, property operations, capital expenditures, income and expense. As a reminder, forward-looking statements represent management's current estimates. They are subject to risks and uncertainties including ongoing developments regarding the COVID-19 pandemic, which may cause actual results to differ from those discussed today. Empire State Realty Trust assumes no obligation to update any forward-looking statement in the future. We encourage listeners to review the more detailed discussions related to these forward-looking statements in the company's filings with the SEC. Certain of our disclosures today are added specifically in response to the SEC's direction on special additional disclosure due to the changes in our business prompted by the COVID-19 pandemic and are unique to this instruction. We do not expect to maintain the same level of disclosure when we resume normal business operations. Finally, during today's call, we will discuss certain non-GAAP financial measures, such as FFO, modified and core FFO, NOI, cash NOI and EBITDA, which we believe are meaningful in evaluating the company's performance. Definitions and reconciliations of these measures to the most directly comparable GAAP measures are included in the earnings release and supplemental package, each available on the company's website. Now I will turn the call over to Tony Malkin, Chairman, President and Chief Executive Officer.

Thanks, Tom. And good afternoon to everyone. It takes a moment to grasp the magnitude of the dynamic situation we all have confronted and continue to confront since we last reported results. And we have adapted to the constant change, flexes, pivots and challenges as a new normal, that our efforts to respond have been effective and that we are prepared to continue this way for an indeterminate period of time through the end of the pandemic, are all testament to the team that is ESRT. We have made hard choices that have resulted in a great deal of change in our organization, reduction in force and cost have positioned us on our front feet to preserve and create value for our shareholders. I'd like to take a moment to say thank you to my colleague, John Kessler, and to extend to him, once again, my best wishes and those of our Board in his next endeavors. At the same time, a public welcome, thanks and congratulations on a remarkable first 3 months to our new CFO, Christina Chiu, who has worked literally nonstop since her arrival and added a tremendous amount of value to ESRT and its stakeholders. We're all better from her contributions and we'll greatly benefit for years to come. Let me say clearly, I have a great deal of confidence in the future of New York City, in the importance of office buildings to the teams and our current tenants and the tenants to come, who will create the value that will lead our economy forward and that the legions of young, smart and motivated individuals who have been and are attracted to this great city will continue to come and make their mark in yet another reinvention of our American dream, a better, more compassionate and inclusive American dream. ESRT is committed to continue to change and be a part of that reinvention for the good of our city, its people and the economy that makes us the only capital of the world that is neither a capital of the state nor country. We can and we will. ESRT's leadership and innovation and redevelopment is our competitive edge. Our buildings and their unique combination of location, value and leadership and sustainability of indoor environmental quality have never been more necessary and have never had a better competitive edge. ESRT as a company has also undergone tremendous change and has never been better positioned for the future. Here's a brief recap of what we have done, where we are and a look at where we will go. Our plan at our IPO was to modernize our properties with the 21st century, consolidate old spaces and redevelop them for new, bigger, better credit tenants on longer leases. We're going to lead in energy efficiency, indoor environmental quality and sustainability. And we would maintain a strong and flexible balance sheet to execute on our strategy and take advantage of potential opportunities that may arise. The redevelopment plan is largely completed. We only have leasing of our remaining redeveloped space and a small amount of space left to redevelopment. Our 4-year redevelopment of the Observatory was completed in December 2019 to fantastic customer reviews and produced strong revenue growth in the first 2 months of 2020. We believe this long-life investment will yield the best results in the future once tourism returns to normal, and we are thrilled amid uncertainty and challenges to have reopened the Observatory as of July 2020. We avoided external growth at market peak pricing. We only commenced stock repurchases when our stock price drops steeply, steered away from co-working and other short-term trends that are visible for what they are in this new environment. We leased to tenants who filled the spaces they initially leased and then expanded by more than 1.7 million square feet to date. As of the end of the quarter, we held $873 million in cash on hand. We continue to engage in share repurchase activity at these depressed valuation levels. In the aggregate, we have purchased $119 million of our common stock at a weighted average price of $8.67 per share through July 28, 2020, through a combination of open window purchases and an in-place 10b5-1 program. We believe current shareholders will benefit long-term from our purchases. We finalized a series of management changes during the quarter as we, in close consultation with our Board, rolled out thoughtful plans for ESRT version 2.0. We laid out our plans to the Board in late 2018. As we can see, it was time for us to move from our plans at IPO in the logical new areas of focus for ESRT, with both new personnel and perspectives. Let me briefly review some of the key new hires and appointments we made over this period: Suresh Rangarajan as our new Senior Vice President and Chief Technology Officer; Dana Robbins Schneider, our new Senior Vice President and Director of Energy and Sustainability; Christina Chiu as Executive Vice President and Chief Financial Officer; Aaron Ratner, our Senior Vice President and Chief Investment Officer; and an internal appointment of a Director of ESG. Importantly, Aaron has hired 2 of the 3 additional team members we agreed, during our discussions with him, would position us to generate and evaluate opportunities and deploy capital for external growth, focused on opportunities in which our balance sheet strength, buy-and-hold philosophy and redevelopment expertise can be brought to bear. We are in a marathon, not a sprint. We will deploy capital when an opportunity that will lead to our growth in the next cycle presents itself. We anticipate opportunities will arise during the next 3 to 4 years in which we, as omnivorous opportunists, of course, will focus our potential to expand to create long-term shareholder value. Our team has risen to all the challenges that have arisen from the COVID-19 pandemic as we pivot and flex our way through. We have gone from a shelter-in-place environment to a return to the office in our Connecticut properties first then to a phased implementation process in New York with the gradual return of our office and retail tenants. Our assets are well positioned for changing tenant demands on indoor environmental quality, with the work we have done as part of our redevelopment efforts. We have met and will meet each challenge with our best organized plans and successful execution borne out of our experience with many different cycles. Strong balance sheet in hand, we have also undertaken a rigorous review of our cost structure. My experience through 6 crises in this business has led us to move prudently and swiftly to reduce operating costs, G&A, CapEx and head count. As disclosed in our earnings release and on Page 14 of the investor presentation and our first round of rationalization, we have undertaken cuts to reduce our 2020 general and administrative expenses by 12% to $60 million. Property operating expenses and building improvement capital expenditures have also been reduced, and Tom Durels and Christina Chiu will go into more detail. Let me provide some highlights. We have implemented broad-based corporate and property-level base salary reductions through year-end, effective August 1. Starting at the top with my 33% reduction, followed by Tom Durels' 25% reduction, scaling down from there. This is in addition to the salary reduction to $1 that I took in the second quarter. Furthermore, we announced that upcoming 2021 annual equity compensation will be reduced by $3.9 million, which consists of $2.7 million for me and $1.2 million for Tom Durels. We have made permanent headcount reductions as well as instituted departmental budget cuts. This is in addition to COVID-19-related cost savings. We've reduced property operating expenses by $10 million in the second quarter and expect further to reduce expenses by $12 million in the second half of 2020. We expect additional savings from a combination of staffing reductions and operational improvements. Furthermore, we've reduced building improvement capital expenditures planned for 2020 by $24 million relative to 2019 levels. These broad-based cost cuts are the start of our efforts to address the current environment, preserve the balance sheet and position ESRT in the long term to thrive and deliver shareholder value. I say start as we are not done. We will take additional measures to reduce costs further after we digest what we have put in place so far. We will see the bright shiny penny of work from home to harness further in the post-COVID environment. We share the belief with the vast majority of businesses that work from home diminishes productivity, team building and culture. Companies that show up, build personal relationships, and develop new products and services will always win. That said, we see the pandemic business environment in 4 phases: first, lockdown; second, post-lockdown, pre-vaccine or cure; third, post-vaccine or cure; and fourth, cleanup and situation assessment. We are not naïve about the current environment. There is no doubt that we will see economic challenges from higher unemployment levels and business failures. We expect the current environment to continue to evolve, but we feel well prepared and ready to flex and pivot to handle whatever challenge lies ahead. That said, New York City is the greatest global economic and cultural capital and one to which people will return for work, to live in and to visit. New York City has come back time and time again from shocks, recessions and tough environments, stronger each time. You'll have an opportunity to touch on these themes more in Q&A, and for now, I would like to turn the call over to my colleague and friend of 3 decades, Tom Durels. Tom?

Thank you, Tony, and good afternoon, everyone. Today, I will comment on our second quarter leasing results, updates on rent collections and deferral requests, actions taken to reduce operating expenses and capital improvement costs, and our health and safety protocols. In the second quarter, we signed 19 new and renewal leases totaling approximately 113,000 square feet. This included about 52,000 square feet in our Manhattan office properties, 47,000 square feet in the greater New York metropolitan office properties, and 14,000 square feet in our retail portfolio. The two significant leases were a 36,000 square foot office renewal lease with Ernst & Young at First Stamford Place and a 10,700 square foot retail renewal lease with Charles Schwab at One Grand Central Place. During the second quarter, rental rates on new and renewal office leases across our portfolio increased by 2.8% on a cash basis compared to prior escalated rents. In our Manhattan office properties, we signed new leases with a positive cash rent spread of 8.7%. Our total portfolio leased percentage is 89.6%, down 150 basis points from the previous quarter. Occupancy declined by 310 basis points during the second quarter, mainly due to the expected move out of two large tenants that we previously announced. These included the Empire State Building, where Coty vacated 157,250 square feet in connection with its expansion lease with LinkedIn, and Thomson Reuters vacating 49,904 square feet at Metro Center. New leasing activity was affected during the second quarter by the pandemic and shelter-in-place rules. During this time, we implemented online measures to maintain relationships with brokers and showcase our properties. While physical tours resumed on June 22, aligning with the Phase 2 reopening, we anticipate lower leasing volumes for the third and fourth quarters based on tenant demand. Regarding rent collections, we've observed steady improvements, with 84% collected of total second quarter 2020 billings, 86% for office tenants and 75% for retail tenants. By July 24, we had collected 90% of July total billings, with 93% for office tenants and 75% for retail tenants. These rates exclude any security deposits or adjustments for deferrals, which have typically been for no more than three months. For local retail tenants particularly affected, we will convert remaining 2020 fixed rents to a percentage rent structure, with payback of the difference over a specified period. We see $42 million of revenue potential from free-rent burnoff and signed leases not commenced. Nonessential construction resumed on June 8, and we've updated the timing of lease commencements. We previously scaled back certain building operations to reduce expenses until buildings are repopulated, lowering property operating expenses by about $10 million during the second quarter compared to last year and projecting a $12 million reduction in the latter half of 2020. Most savings are COVID-related and are expected to decrease as occupancy rises. It's important to note that a part of the operating expense reduction will be offset by decreased tenant expense recoveries. We have also implemented permanent cost savings of around $4 million annually through staffing and other reductions. Our buildings are fully open, and we have established health and safety protocols, including temperature checks, mandatory masks, hand sanitizing, and increased cleaning of high-touch areas. Additionally, we have a comprehensive indoor environmental quality program aligned with tenant requests, including MERV 13 filters in our controlled air conditioning systems, increased ventilation, regular quality tests, thorough cleaning, and active air purification in select locations. As mentioned earlier, we've taken steps to reduce capital expenditures, nearing the completion of our redevelopment work. We now expect that 2020 capital expenditures for building improvements will be approximately $24 million lower than in 2019 as we concentrate on mandatory spending and previously started projects.

Thanks, Tom. I'd like to begin by saying that I'm very excited about joining ESRT in May of this year. Since then, I've worked closely with the various departments to ensure a smooth transition and to settle into this role. I met many of our investors and analysts virtually in May and June and look forward to meeting more of you over the coming months. Now let me start with our quarterly results. For the second quarter, we reported core FFO of $39 million or $0.14 per diluted share. This is net of $0.03 per share of expense from a reserve against tenant receivables and noncash reduction in straight-line rent balances and excludes $3 million in severance costs and a $4 million impairment charge, both of which I will address later. Same-store property operations, if you exclude onetime lease termination fees and Observatory results from the respective period, yielded an 18% cash NOI increase from the second quarter of 2019. This increase was primarily driven by lower property operating expenses, partially offset by a reserve against tenant receivables. When COVID-related rent deferrals are excluded, same-store property cash NOI increased 9.9% from the second quarter of 2019. More detail on rent deferrals and the breakdown of our collections can be found on Page 10 of the investor presentation. During the quarter, we recorded a number of unique items that are largely noncash and are added back to core FFO. Specifically, we recorded a $4.1 million noncash impairment charge related to the write-off of prior capitalized expenditures on a combined heat and power generation project for the Empire State Building that has been rendered economically unfeasible due to New York City's Local Law 97 and a $3 million onetime charge in G&A expenses related to the departure of our former COO, of which $2.7 million is the noncash accelerated vesting of equity compensation. We also reported a $9.1 million reduction in rental revenue in the second quarter comprised of $1.9 million reserve against tenant receivables and $7.2 million against straight-line rent balance. This equates to 1.6% of our annualized rental revenue as of June 30, 2020 and a $0.03 FFO impact. We reached this determination after a review of each tenant's arrear status, security deposit balance and management's assessment of the path towards a resolution and viability of the tenant. Turning to our balance sheet. As of June 30, 2020, the company had total debt outstanding of approximately $2.5 billion on a gross basis and $1.6 billion on a net basis. The company's total debt has a weighted average interest rate of 3.41% and a weighted average term to maturity of 6.9 years. Our consolidated net debt-to-total market capitalization was 43.7% and consolidated net debt-to-EBITDA was 5.2x. We have no near-term debt maturities and a well-laddered maturity schedule. Our revolving credit facility expires in August 2021 and has 2 6-month extension options. Our next maturity isn't until November 2024. As we look ahead to the second half of the year, here are a few items to keep in mind. We noted earlier that we undertook a series of proactive steps to reduce our G&A expenses, property operating expenses and capital expenditures. Tom already covered property operating expenses and CapEx, so I will focus on G&A. We now anticipate 2020 expenses of $60 million, excluding onetime severance charges. This is approximately 12% less than the previously disclosed G&A run rate of $68 million that we provided on our 4Q 2019 earnings call. As detailed on Page 14 of the investor presentation, the reduction falls in 2 categories: named Executive Officer compensation and other corporate overhead. Named executive officer compensation reduction include $400,000 from the reduction in annual base salary for Tony Malkin and Tom Durels through December 31, 2020, $1.2 million from the change in age requirement from 60 to 65 for the accounting vesting period for time-based equity compensation and $2.7 million from the departure of our former COO. Other corporate overhead reductions include $1.5 million of net savings from reductions in corporate staff and corporate salary reductions through December 31, 2020, partially offset by the addition of investment personnel, and the balance is from department budget cuts and lower anticipated spending due to COVID-19. As mentioned by Tony earlier, 2021 NEO annual equity compensation will be reduced by $3.9 million. We currently expect 2021 G&A run rate of approximately $58 million, and we will continue to seek efficiencies and cost reduction opportunities in operating our business. We believe these proactive measures, particularly on G&A expenses are aligned with our stakeholders and reflect our efforts to preserve cash and operate efficiently in uncertain times. We will continue to seek the right balance as market conditions evolve. Now I'll turn the call over to Tony to provide some thoughts on our Observatory business.

Thanks, Christina. Before we go to Q&A, here is an update on the observatory now that we have reopened the expense picture on a go-forward basis. We started the year on a strong basis following the completion of our Observatory redevelopment program in the fourth quarter of 2019. Revenue for the first 2 months was up 13.2% year-over-year, excluding the impact from the 102nd floor Observatory. This revenue growth occurred despite the absence of Chinese New Year activity in January and a pullback in visitor traffic in March from European countries where COVID-19 was rampant. We followed the mandate of government authorities and closed the Observatory on March 16, and the Observatory remained closed for the entire second quarter. The 86th floor Observatory reopened on July 20 with new protocols and processes under New York State's Phase 4 guidelines. We still await permission to reopen the 102nd floor. We have updated our hypothetical admissions ramp up on Page 18 of our investor presentation. It assumes 2019 monthly levels as the baseline visitation comparison reference point and uses our reopening date of July 20, with a gradual ramp-up towards normalized levels by 2022. We have been open for just under 2 weeks now and slowly rebuild the beach that is our business one grain of sand at a time. Our focus on indoor environmental quality, in which we have been leaders for more than a decade, yielded air filtration through MERV 13 filters, an aggressive response to viruses with AtmosAir and a massive capacity to ventilate the Observatory as part of our redevelopment. Combined with comprehensive protocols and employee training, this has made it possible to reopen. Our expectations for a more gradual ramp-up align with our channel checks with other Observatory operations around the world, which have seen to date a gradual volume buildup as they reopen in the respective countries to a 20% to 25% level of prior year's operations. We are confirmed in our anticipation initially that we will have a higher local visitor mix followed by a ramp-up of regionally than nationally sourced travel and then followed by a restoration of our typical visitor mix that is approximately 2/3 international. We do not think we'll achieve normalization until the broader resumption of international air travel, and we presently peg that for some time in 2022. While the Observatory was closed, we remained relevant and active in the promotion of our brand through numerous initiatives from our pandemic fire and lighting over the skyline of New York City to our partnership on the Fourth of July with Macy's Fireworks finale with fireworks shot off the top of the Empire State Building. If you missed it, take a moment and look at our YouTube channel. You'll be impressed and entertained. With our July 20th reopening, we posted a detailed presentation to educate the general public that we are open for business and ready to welcome visitors in a safe and enjoyable environment and have since launched a social media push. No attraction in any city has higher brand value and international recognition than the Empire State Building Observatory, authentic and iconic. We believe when the pandemic passes, we will emerge stronger than ever and remain the brand and icon of New York City. On the expense side, we wanted to share an update on how to think about expenses as we reopened. Previously, we had communicated that we reduced our typical annualized expense run rate by 60% from $35 million in February to $14 million by May. In the second quarter, Observatory expenses totaled $4 million. Now that we have reopened, we calculate our annualized expense run rate to approximately $25.5 million. There are certain fixed staffing and operational costs, regardless of volume levels. For example, we need to maintain staffing to operate the real call desk, security, elevator loading unloading and deck attendance regardless of whether we have 1 or 1,000 visitors at a time. We believe that we have ample bandwidth to handle our anticipated ramp-up in admission volume through 60% of 2019 volume levels with current staffing. With this completed, I'd like to open the call for your questions. To keep the call moving, as always, we ask that each participant limit him or herself to 1 primary question and 1 follow-up. Please do feel free to rejoin the queue if you have additional questions. We will stay on the call as long as we have questions. Operator?

Our first questions come from Craig Mailman of KeyBanc Capital Markets.

Tony, I appreciate your comments at the beginning of the call about the long-term conviction in New York City. I have a question regarding some recent livability and quality-of-life issues we are seeing, which may hopefully improve, but it's uncertain how long they will persist. At this point, your team is expanding its investment efforts. Is there any consideration being given to exploring markets outside of the New York metro area that might be promising for capital deployment?

Thanks very much for the question. I appreciate it. We really view ourselves as omnivorous opportunists, and at this point, in what I view as a 3-4 year opportunity, I really don't want to limit our options on anything. That said, we certainly have certain skills in New York City. I've lived through times of much greater livability challenges than we presently have in New York. And the fact is every dollar of capital that we have, we have to patiently and prudently evaluate all our options to look and focus on how we generate shareholder value. So while I would like to say that it's very straightforward, I think there are some things that obviously would fit in with us clearly and comfortably, and there are other things, candidly, which might be out of the box, and we just have to look at it all against how we use our capital, anything from buying our own stock to buying debt, joint venturing, different product types, different locations.

That's helpful. And then just on the retail portfolio, you guys have 17% of rents coming from that segment. As you guys are looking at the creditworthiness of those tenants, and I realize a lot of it is sort of amenity-based. What's the viability even with going to percentage rents of the majority of those tenants here as the pandemic drags on and restaurant reopenings keep getting kicked down the road?

I absolutely think that when it comes to food service, there are specific challenges. We need the bodies in the buildings in order to justify people and their activities. And as far as in-store dining, that's challenged by the fact that, frankly, people need to deploy the protocols that we have in our spaces, including our retail of MERV 13 filters, AtmosAir and fresh air ventilation. That said, I think that we'll see people pivot and flex. We're at 'percentage rent' if people aren't open and they're not doing sales, that means their rent is 0. And I think over time, our strong credits, our strong tenants, those rents are in the bag, and those people have long-term use. We may see failures in the smaller amenity-based tenants. And as people return to the offices, which they will, those people will either restart with new businesses, or we'll have other folks come in. We'll see a downward adjustment in rental pricing. And I think as far as retail in New York is concerned, there are certain very large boxes that have been occupied by tenants that won't be in business anymore, that are permanently disabled and need to be redeveloped.

Tony, just staying on external growth. I think the way you've sort of framed the 3- to 4-year opportunity seems to be a slower cadence than the excitement that you shared on last quarter's call, which seemed to be a coming fork in the road and taking it. It seemed a little bit more near-term in terms of deploying that capital. Is that fair?

I believe, Michael, that the main excitement for us is actually the fork in the road. We view everything as part of a long-term journey. Decisions in real estate that create lasting value must be able to endure through a cycle. We're not suggesting that the opportunities will arise specifically between years 3 and 4. Instead, I think we will experience a downturn where pricing and efficiency will initially improve, potentially leading to better pricing efficiency as more transactions occur. We will also have to manage the overall market recovery. Historically, this situation creates a buying opportunity that extends for about 3 to 4 years through a cycle. Currently, we are at the start of a downturn, entering a new cycle, which provides us with several months to deploy capital. However, that doesn't imply that we aren't actively involved. I'm really pleased with what Aaron has accomplished. He has already selected 2 out of the 3 hires he aimed to make, with one person already working with us for over a month. We're examining a significant number of different opportunities, including a few transactions we initially missed out on. Now, we can reassess the senior debt and other aspects, identifying opportunities to re-engage with projects we've already underwritten. I hope that clarifies things, and if it doesn't, feel free to ask further questions, and I'll do my best to provide clearer responses.

Yes, that information is useful to have. I understand you implemented the stock buyback again during the quarter. How does the current trading price of the stock influence your decisions on capital deployment, whether for debt or assets in New York or elsewhere? What guidelines do you and the Board, along with the management team, follow in this regard? Once the money is spent, it is no longer available, so how do you manage this aspect, especially considering the stock is at significantly low levels?

Thank you for the great question. I believe it's important to note that we carefully consider our cash during capital allocation. We assess potential new deals against how we would utilize the funds, including stock buybacks, dividends, external reinvestment, and our outlook on market cycles. Additionally, we have a strong partnership with the Qatar Investment Authority, which has consistently shown interest in collaborating on valuable opportunities. I'm also pleased to have Aaron Ratner on board, given his experience with joint ventures and institutional capital management. We view our capital as a resource that can be enhanced by leveraging external capital, allowing us to deploy both financial resources and our expertise. As we continue to differentiate ourselves, I believe our stock price will rise. We also have the option to engage in joint ventures, using our funds as seed capital for larger initiatives.

This is Elvis on for Jamie. Tony and maybe Christina, can you talk a little bit about the lingering credit risks/write-downs that not only occurred in the quarter, but could potentially occur in the future? How should we be thinking about your portfolio versus some of the other write-downs that we've seen across the sector?

I will start by discussing this and then pass it to Christina. We can only write off rents that are owed to us but not paid. At that point, we will examine the cash component and then consider the straight-line component. We are actively engaged in requesting deferrals from tenants who have not paid. As you can see, we have made significant progress in our rent collections. This process is very real; it feels like being in a war rather than just an exercise. Looking ahead, I will let Christina share how she has approached this, working with her team in leasing and real estate as we evaluate our collections.

Sure. I would like to refer you to Page 10, which contains our total billings collection update. Notably, we present this information month by month, totaling 100 on an unadjusted basis. To address your question, this reflects our process of determining write-offs and our flexibility in managing accounts receivable. We conduct a thorough evaluation with our leasing team for each tenant in arrears, examining their overdue amounts, payment patterns, security deposit balances, and the likelihood of collecting unpaid amounts. Based on this analysis, we arrived at the $9.1 million write-down, which includes $1.9 million in uncollected tenant balances that we need to monitor closely. The rest pertains to straight-line adjustments, and we will keep an eye on those as well. In the chart, you can see that in July, straight collection reached 90%, which is still unadjusted. We have a portion of uncollected funds supported by security deposits and another portion that remains uncollected. We are observing improvements, and as time progresses, we will continue to use these categories for careful assessment, taking write-downs when we determine that the likelihood of repayment is low.

Okay. And then maybe one for Tom. Tom, you mentioned on the call having lower expenses but also having lower recoveries. Some of the beats have been on lower expenses. But how does that look sort of within the quarter versus future quarters and thinking about these lower expenses versus collecting lower recoveries for tenants? How should we be thinking about that?

Well, as I commented earlier, in the second half of 2020 compared to the second half of 2019, we expect to reduce operating expenses by $12 million. And then on a go-forward basis, in 2021, we eliminated $4 million of recurring staffing and other expenses. So these are unrelated to COVID, and these are permanent reductions. A percentage of our expenses will be recovered by operating expense escalations. But as we reduce those expenses going forward, then you'll see a strong decrease in operating expense escalation. We haven't given a specific number, but it's not a 100%, but a portion of those expense reductions.

Our next question comes from the line of an analyst at BMO Capital Markets.

It's been just a week since the Observatory reopened. I'm just curious how has the visitor traffic been so far? And are you considering any possible changes in pricing, either more in premium or conversely possibly promotions to attract more visitors?

Thank you for the question. We are not going to disclose any specific numbers during this call, but we are confident that our visitor numbers meet our expectations. They also reflect the reopening trends experienced by other tower operators worldwide with whom we frequently share insights. Many of them are observing that internal travel, particularly by car, has reached about 20% to 25% after a few months of operations. From that standpoint, we are in line with those figures. We have not altered our ticket pricing and do not plan to do so. Our visitors have provided excellent feedback on social media, indicating that they prioritize safety first, and then the breathtaking views and overall experience. We believe these positive reviews will encourage more people to visit. Week 2 has shown stronger performance than week 1, and our first weekend exceeded the previous week's results. We are looking forward to the upcoming weekend. Additionally, almost all of our sales are currently made directly through our website. As more New York City attractions reopen, like museums such as the Met and the 9/11 Museum, and as the city receives more promotional attention as a destination, our past and online travel agency partners will have more offerings to promote. Interestingly, our per capita spending is quite high at the moment since the majority of ticket purchases are made directly online. I hope this information is helpful, and I am happy to answer any further questions.

Yes. No, that was helpful. And then just a follow-up on that. In your hypothetical Observatory assumptions, when do you expect or which quarter to increase the 500 capacity level?

The 500 capacity level was a number we designated. Under Phase 4, we have opened as an outside attraction, which is why the 102nd floor is currently closed and only the 86th floor is accessible. We can increase our capacity based on demand and when we feel confident that all the protocols we have implemented are being followed by our visitors and properly enforced by our team. The team underwent several days of training before we reopened. We are aware of the thorough review we received from both the Governor's office and the Mayor's office, who both concurred that we are in a good position to reopen. We want to show that we can adhere to the protocols we've established. We will communicate carefully with them before making any decisions about increasing our capacity.

Tony, I was hoping if you can speak to maybe the type of demand you're seeing, albeit understanding that demand is lower now because of the post-COVID environment we're in. But if you could just speak to the suburbs versus the city and the type of tenants that are looking in both areas and if you've noticed an acceleration afterwards.

Look, I think the comforting news for us is that we actually have seen tours. We have active proposals. We have some approved deals. But for the actual detail as to from where it comes and where it's headed, why don't I hand this over to Tom Durels for him to make comment.

Sure. Thanks, Tony. Lease tours have resumed in Manhattan, and in July 2020, our volumes were about 40% compared to 2019. It's important to note that the Phase 2 opening in Manhattan began on June 22, so we are still relatively close to that date. We are happy to see tours are back on track at approximately a 40% pace. As Tony mentioned, we have received some recent proposals for full floors at 111 West 33rd Street and the Empire State Building, along with pre-builds at 1350 Broadway, the Empire State Building, and One Grand Central Place. For leases that were in negotiation before the shelter-in-place orders, some have been finalized and contributed to our second-quarter figures, while others are still being negotiated. We hope to finalize those, though some deals did not go through. We anticipate lower leasing volumes in the third quarter, particularly since we were unable to conduct tours during the entire period when the shelter-in-place orders were in effect. However, we are pleased that tours have now resumed.

Great. That's helpful. I wanted to ask about the write-off at the Empire State Building concerning the capital improvement projects. I believe Local Law 97 was passed last year. Can you provide more details on what made that project uneconomical? Also, are there any other initiatives taking place at your other properties?

So that wasn't the only project where we had an actual combined heat and power system implemented. It made a lot of economic sense. We worked with the Governor's office to obtain an exemption for a pilot program to examine the Con Ed standby tariff rates that would have previously rendered it unfeasible. We believe strongly that from an environmental standpoint, it makes a lot of sense because the efficiency in capturing waste heat for steam for the chillers and hot water for the building is exceptionally high. The challenge lies in Local Law 97, where I serve as the only representative from the real estate industry on the Mayor's advisory board for the implementation of this law. There have been some arbitrary values established for greenhouse gas emission coefficients, resulting in a lack of a clear pathway under the current regulations for the assessment charges associated with greenhouse gas emissions from a combined heat and power plant, which may not be economically viable due to the significant operational charges added each year. Therefore, if we can restructure this, we will. I am actively involved with the Mayor's advisory board on the implementation of the law. One goal is to discuss how to accurately measure the greenhouse gas coefficient of combined heat and power plants. However, Christina noted that given the current framework and the established levels, they are making it unfeasible. It is a logical time to write it off.

Just a follow-up here. As you think about the OpEx savings and kind of just looking at the fiscal kind of outlook for the city, I mean, how much of this could just be eaten up by higher taxes as we head into '21 and '22, property taxes?

Certainly a risk, Craig. Certainly, a risk. So I think that one of the reasons that we need to be careful to Michael's earlier question about how we look at underwriting our opportunity set, we got to take a look at what happens on the fiscal scene. Every city in the United States, not just New York City, has been tremendously adversely impacted by the COVID pandemic. I think the good news is, candidly, there's a lot of fat in the New York City budget. During the de Blasio administration, there have been significant increases in a lot of programs, creations of new programs, which are ideologically and I think directionally logical. However, when it really comes down to what makes the difference to deliver services to allow the city to function, there's a lot of fat that could be cut. And I think it's important to note that this Mayor and this City Council, 2/3 of the City Council will be gone as of the next election cycle in 2021. Everybody's term limited out. So it's going to be a very interesting set of developments, I think, as we go forward. And it's one where I think we just need to be careful when we look at committing new capital.

And then just on the CapEx savings you guys have, it sounds like some deferred repairs and maintenance. I mean, how much of that is just going to land in '21? Is this kind of the timing decision there just because some of that could be passed through to tenants. Do you want to make sure people are in a space to be able to pass it through? Or is some of that permanently avoidable?

Tom?

Sure. Craig, this is Tom. As we commented, we're near the end of our redevelopment program. And so we're seeing the benefit of that. We had anticipated a decline in our CapEx spend going into 2020. But certainly during this environment, we took a look at everything. We've deferred those things where we can get more life out of equipment or systems, and we're focusing on executing and completing the work that we had commenced pre-COVID. and we're prioritizing only those things that are going to generate income. But the big picture is that we're nearing the end of our redevelopment. And so I think we're in good shape. I'm pleased with the reductions. We're closing out a lot of work at the Empire State Building and throughout the portfolio, and that's what we're trying to wrap up this year.

There are no further questions at this time. I would now like to turn the call back over to Mr. Malkin for any closing comments.

Thank you, Operator, and thank you to everyone on the call. We managed to adapt well to the current situation, even if we couldn't all be in one room. I want to commend the team for making this happen. I appreciate the time and effort that went into this quarter's disclosures, which are more detailed than usual. We believe this will assist you in your analysis. Please keep in mind that any forward-looking statements about our plans for the Observatory and our business operations are purely for discussion and not formal guidance. We'll need to adjust based on travel conditions and the ongoing COVID pandemic. I also want to express gratitude on behalf of the Board and myself for the hard work of all ESRT employees during these challenging times. Our team has remained calm, resilient, and proactive, which will help us navigate the future. While we have had to make some difficult decisions regarding staff reductions and compensation adjustments, we will be conducting further reviews of costs moving forward. I look forward to connecting with many of you virtually in the upcoming months, whether through roadshows or conferences, and I'm eager to share our third-quarter results in October. Until then, please take care and stay positive.

This does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.