Empire State Realty OP, L.P. Q1 FY2021 Earnings Call

Greetings, and welcome to the Empire State Realty Trust First Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce Tom Keltner, Executive Vice President and General Counsel. Thank you. You may begin.

Good afternoon. Thank you for joining us today for Empire State Realty Trust's first quarter 2021 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.

Thanks, Tom, and good afternoon to everyone. We remain confident in the recovery of New York City, realistic regarding where we are and what we must go through to achieve that recovery, and well-positioned with a balance sheet that gives us a long runway and the ability to take advantage of growth opportunities. The U.S. vaccination rollout, stimulus spending, and the reduction in New York State pandemic-linked restrictions all signify a much better spring than any period we have had since lockdown in March 2020. Daily, there are new announcements from arts, cultural, hotel, hospitality, and entertainment venues, all serving to reflect remarkable and growing demand from New Yorkers to get out and enjoy their city. Rental apartment occupancy is up, and apartment sales have increased. Schools are back in session. Airlines have announced rehirings and increased domestic flights. Even if the much-discussed 100% of 2019 domestic schedules by summer does not occur, directionally this is good news.

Thank you, Tony, and good afternoon, everyone. In the first quarter, we signed 26 new and renewal leases totaling approximately 172,000 square feet, which included approximately 143,000 square feet in our Manhattan office properties, 28,000 square feet in our greater New York metropolitan office properties, and 1,000 square feet in our retail portfolio.

Thanks, Tom. For the first quarter, we reported core FFO of $41 million or $0.15 per diluted share. Same-store property operations, if you exclude one-time lease termination fees and Observatory results from the respective period, yielded a 3% cash NOI increase from the first quarter of 2020. This increase was primarily driven by lower property operating expenses, partially offset by lower revenue as compared to the prior year period, driven by receivable write-offs and increased vacancy. Our rent collections remain stable at 94% of first quarter 2021 total billings, with 96% for office tenants and 86% for retail tenants. The company recorded a non-cash reduction of straight-line balances of $0.6 million and wrote off $0.5 million of tenant receivables assessed as uncollectible during the first quarter of 2021. Switching to Observatory results, Observatory revenue for the first quarter of 2021 was $2.6 million, which included $0.1 million of deferred revenue from unused tickets and earned income from our tour and travel partners. Observatory expenses were $4.6 million in the first quarter of 2021, which is our seasonally lightest quarter, and we continue to expect run rate expenses to be approximately $6 million to $7 million per quarter for the balance of 2021, depending upon the pace of visitor ramp-up. Turning to our balance sheet, as of March 31, 2021, the company had $1.4 billion of liquidity, which is comprised of $567 million of cash and $850 million of undrawn capacity on our new revolving credit facility entered into at the end of the quarter. The credit facility has an initial maturity of March 2025 and has two six-month extension options and a sustainability-linked green pricing mechanism that reduces the borrowing spread if certain benchmarks are achieved each year. The company had total debt outstanding of approximately $2.2 billion on a gross basis and $1.6 billion on a net basis at March 31, 2021. The company’s total debt has a weighted average interest rate of 3.9% and a weighted average term to maturity of 7.9 years. We have a well-laddered maturity schedule with no outstanding debt maturity until November 2024. Our net debt to total market capitalization was 32.6%, and net debt through adjusted EBITDA was 6.5 times. Year-to-date through April 27, 2021, the company repurchased $3.5 million of common stock at an average price of $9.22 per share. This brings the cumulative total since the stock repurchase program began on March 5, 2020, through April 27, 2021, to $147.2 million at an average price of $8.34 per share. Our balance sheet flexibility provides us with an operating runway to engage selectively in share buybacks and evaluate opportunities to deploy capital for external growth. Our investment team continues to underwrite office, retail, and multifamily opportunities actively. As we have emphasized, we will prudently deploy capital when an opportunity presents itself.

Thank you. The first question comes from Steve Sakwa at Evercore ISI.

Thanks, good afternoon. I was hoping that maybe Tom could speak a little bit more about the demand, and I guess specifically just sort of thinking about how tenants are looking at density as they are looking for new space? And for the deals that you said you got an increase in activity, are those just kind of reloads? Are they new deals, are they expansions, downsizing? Just a little color would be helpful.

We are back to about two-thirds of our pre-COVID pace for space tours. Of course, any of these showings that lead to proposals will likely occur in the second half of the year, but it's a really good sign that tenants have re-engaged in the market. Indoor Environmental Quality and Healthy Buildings remains the primary focus by most tenants and it's often a gating issue before tours are scheduled, and it's certainly the most frequently asked about topic during tours. About half the proposals we see right now represent tenants that are growing, and the other half are lateral moves. We've had a really good quarter. 172,000 square feet of leases are done, and I think that we're seeing a mix of tenants in legal, tech, financial services, government, and media, so it's a good mix of tenants that we are seeing.

Okay, thanks. I guess the second question, Tony, in your comments as well as in the press release, you talked about a real step-up in your activity levels looking at transactions, and I also noticed the share buyback volume was rather minimal this quarter. I don't know if those two were tied together, but could you maybe speak a little bit more about the types of deals that you're seeing, if it's more distressed or just the fact that the markets are getting better and the debt markets are open that more products are coming to market?

Sure. Thanks, Steve. Our team is busy. Our new team and our seasoned players like Tom Durels and his property team and John Hogg and his FP&A team are looking at a broad variety of situations. Our focus remains on New York City, office retail, and multifamily. We are in conversation with families, many of whom were not interested in talking about transactions four or five years ago who are more interested now. We have seen widely marketed transactions; we’ve seen off-market transactions and M&A. When we have something, we will let you know and will give our rationale. As far as the source and motivation of the transactions that we see, I would say quite similar to the leasing, things just have begun to move. People have begun to make moves, come out of their shells, recognize things they have to do, recognize things they would like to do. I think it will take time to see price discovery come out on different assets as more deals are announced and will see more folks come to terms with whether they are in a good position with a good runway or need help.

And maybe just as one follow-up there, Tony, does the potential for capital gains tax or the elimination of 1031s, kind of accelerate some of that activity or do you not think either of those have a significant driving factor in transaction volume?

Look, I think it's highly conjectural at this point. We don't see anything that really evidences there. The only thing we feel reasonably confident about regarding the tax situation is that the Biden Administration would like taxes to go higher. There is a dialectic in Congress and the democratic majority in the House is not large, and therefore, to get any package passed, there is a growing contingent of House of Representatives members who have said they will not approve anything without a removal of the cap on state and local tax deduction. We think it’s hard to predict the outcome of any potential decision, but any decision that lessens the burden on high-income earners in our region is very positive.

Great, thanks. That's it from me.

Thank you. Our next questions come from the line of Manny Korchman with Citi. Please proceed with your questions.

Hey Tony, you've spoken about this 1Q 2020 to date a couple of times now. You called the bottom, but what does the path to the bottom look like? Is that going to be an increase in vacancy or sublease space? Is that going to be rent dipping? Is that going to be tenants leaving the market? Others have maybe been sort of more on the path of seeing the bottom, which is activities, at least you know leasing activities are, but tours are up, but you're saying that we have to wait a year to see when the bottom hits. So, what does that path to that look like?

Thank you for the question, Manny. Uneven starting points of data can lay the foundation at this point, but what we've seen in prior periods is that more space gets put on the sublet market than what has ever sublet. More space is discussed to be shared than is ever actually shared. We see that at times like this where things are not necessarily restarted entirely, many will try to generate business with big incentives and discounts in rent. Brokers will go out with initial proposals that are radically low. In the upcoming period, we do not expect to see a lot of what establishes the base. We'll see some hesitant commencements, and we'll obtain price discovery. A significant component of the future of work conversation has turned into calls for a return to office now that the world has begun reopening. Companies recognize the difficulties related to culture, team cohesion, and competition not only from work from home, but also from the proposed hybrid future. There are a lot of motivations occurring, and as we move forward, this will build clarity about what people's use will be, though it's hard to predict if we won’t see more bad news until the end of the first quarter of '22. Directionally, things have greatly improved, and I think they'll continue to improve.

Great, thanks Tony. Maybe you touched on this a bit in Steve's response, but when you say your teams are busier than they've ever been over the last three months compared to the entire history of the company, is that just looking under more rocks? Have you had more imbalance or more receptivity to offers you’ve made? What are the levers you hope to increase the activity or volume of work?

I would say it’s three things. The first answer is all of the above. In every avenue, multiple families have come back to discuss issues they need to resolve. They won't all lead to transactions, but people are assessing their situations more actively. We've also spent productive time working with our Board and Finance Committee to put a good process in place. Finally, we have a full team now underwriting and analyzing numerous situations and looking at all different structures to make us competitive, aligning it against our capital allocation. So, hopefully, that’s helpful, but it's coming from all angles, and it reflects our return to an expansion mode where we haven't been as a public company. We're pleased by that.

Thanks Tony.

Thank you. Our next questions come from the line of Blaine Heck with Wells Fargo. Please proceed with your question.

Great. Thanks, good afternoon. Just a follow-up on that, Tony, I know you don't want to focus too much on transactions until you get something done. Christina, both mentioned that you're looking at office, retail, and multifamily opportunities. Are there more opportunities in one property type than another? And how do your skills in office and retail translate to acquiring and operating multifamily?

I will focus on the matter of multifamily. We've done a lot in this sector historically, and outside the REIT, my family still owns thousands of apartment properties, not in the New York area. We’ve developed multifamily for sale in New York City and turned around multifamily assets before. Members of our team involved in that and underwriting on the property side are still here. We believe we've got good experience in that area, and it's an interesting potential additional wheel on our tricycle.

Okay, that’s helpful. I guess, shifting to the balance sheets, you obviously have enviable liquidity, but leverage has crept up a bit over the past several quarters. Christina, can you talk about where you are comfortable on a debt-to-EBITDA basis? I think you're at 6.5 times now on a net basis. Are you running into any constraints on the share repurchase or potential investment side, or not at this point?

We are not feeling constrained. We are happy with our liquidity position of over $550 million of cash and $850 million on our new line, now maturing in 2025. We have no debt due until November 2024, so we feel good about the flexibility we have. Regarding net debt to EBITDA, we don't focus strictly on an exact level; it’s about access to further liquidity. The company has always taken a conservative stance on the balance sheet. While the increase in net debt to EBITDA is largely driven by declines in observatory revenues, we are managing expenses effectively and feel comfortable at these levels.

I'd like to add to Christina's comments. We are prepared to leverage up and also prepared to issue more equity at the right time. We recognize there is a virtuous cycle in which we may find ourselves once we commence growth. We’ve bought stock back at a price below our current trade level; we may reissue that stock at a higher price, benefiting our investors and increasing liquidity. We feel we are in a very good position and well-prepared. If there is one thought I wish to communicate, it's that we feel well positioned and are working hard.

Very helpful. Thank you all.

Thank you. Our next questions come from the line of Craig Mailman with Keybanc Capital Markets. Please proceed with your question.

Thanks everyone. Maybe I'll circle it back to Tom and your commentary on the leasing front. The pickup in tours is a good future indicator, but I'm curious if your portfolio has served as a bit of a value relative to traditional midtown office buildings. In these situations, do you see a trade-off of space among tenants? Has the demo of the tenants shifted at all?

I would point out that Zentalis and Burlington were both growth tenants committed to long-term leases. We are seeing growth in the market, with about half our proposals representing tenants that are expanding. We've seen upgrades in tenants moving to our properties from inferior ones due to our well-located properties next to mass transit and fully redeveloped, modernized buildings.

Great, thanks for the color. The $11 million reduction in OpEx in the first quarter is strong; how much of that $11 million is permanent, and can you materially improve the NOI margins at a stabilized point versus historic levels?

We are actively looking at ways to improve operational efficiency and lock in permanent savings. The reductions represent aggressively managing expenses. While the bulk was due to reduced occupancies related to COVID-19, we've completed redevelopment work that allows us to cut certain expenses permanently. We expect to lock in a portion of those savings and improve on 2019 utilization numbers.

Great, thanks guys.

Thank you. Our next questions come from the line of Jamie Feldman with Bank of America Merrill Lynch. Please proceed with your questions.

Great, thank you, good afternoon. I was hoping you could talk a little bit about the small tenant leasing activity versus larger. You were able to keep your percent lease flat, which is impressive. Looks like a couple of buildings had occupancy dip a bit. Curious if there’s any kind of read through for small tenants versus larger tenants based on what you’re seeing?

Sure, the increase and decrease in occupancy that you noted from the prior quarter was due to known moveouts we had communicated. The most significant was the termination of a full-floor tenant for 40,000 square feet, which we have already leased to ClearView, with their lease commencing by the end of this year. Our forecast of 300,000 square feet of tenant vacates in 2021 has not changed significantly from prior forecasts, and we expect 305,000 square feet of signed leases to commence by year-end, so we’re in good shape.

Okay, thank you. You mentioned a 10% to 15% reduction, can you break that out by face rents, concessions, free rent, and TIs?

Every deal is unique and depends on various factors such as space condition, location, tenant credit, etc. For example, the Burlington expansions and Zentalis and Belkin leases were turnkey deals, generally with negotiation around concessions. Our average lease costs this quarter for TIs and commissions was about just under $9.5 per square foot, which is in line with all of 2019, with a weighted average lease term this quarter of 10 years, favorably comparing to the last couple of quarters.

Thank you. Just to be clear, would you consider assets outside of New York City or NED level transactions if they did include assets outside of New York City?

Our focus remains on Manhattan and the greater New York metropolitan area. We need to look at all types of transactions, and while we want to avoid speculation, we must be prudent to our stakeholders and investors.

Okay, but is there a regional limit? Would you consider national assets or west of the Mississippi River?

Joking aside, we really need to look at all logical opportunities for capital allocation. We're eager to have something to discuss beyond speculation, and will be more forthcoming as we do.

Thanks for that. Any thoughts on the suburbs? The portfolio looks relatively flat on the occupancy side.

We have a 63,000-square-foot lease with Berkeley Insurance commencing later this year, which will help our occupancy numbers. There’s been a pickup in tours and that volume currently is near pre-COVID levels. It is a bit early to see how this translates into activity in the second half of the year, but significant improvement is expected.

It’s noteworthy that we haven't seen a large migration of tenants out of New York City; there have only been a handful, and some smaller leases have been reported.

Thank you. There are no further questions. We will finish up here. I want to compliment our great team. Without them, ESRT is nothing. Please review our sustainability report when you get a moment. It highlights our commitment to renewable wind energy and healthy buildings, offering insight into our direction, as presented in our first annual sustainability report. Lastly, our forward-looking statements are for discussion purposes only and are not guarantees. We look forward to meeting many of you at the upcoming virtual May conference and hope to see you return to the office. Thank you. Thank you. This does conclude today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.