Empire State Realty Trust, Inc. 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 with regard to where we are and through what we will have to go to get to that recovery, and well-positioned for the 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 reduction in New York State pandemic-linked restrictions all speak to a much better spring than any period we've had since the lockdown in March 2020. Daily, there are new announcements from arts, cultural, hotel, hospitality and entertainment venues, which all serve through 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 that 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 and that 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. Looking ahead, there are a few items to touch upon for your modeling consideration. We reduced property operating expenses by roughly $11 million in the first quarter of 2021 on a year-over-year basis, driven primarily by reduced building utilization. The company expects property operating expenses in the second quarter of 2021 will approximate our current levels based on continued low building utilization relative to 2019 levels. Also, the company expects annual G&A to be approximately $58 million. And now we will turn it over to the operator for Q&A.

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 for just kind of re-loads? Are they new deals, are the expansions downsizing, just a little color would be helpful?

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. And of course, we encourage everybody to look at our sustainability report on our website. I'd say about half the proposals are new activity that we see right now and represent tenants that are growing, and the other half are lateral moves. But if you look at this quarter, we're pleased with the expansion lease we did with Burlington and the new leases with Zentalis and Belkin. These represent growth by tenants who are committed to long-term leases in the middle of the pandemic. On spaces, we haven't really seen any significant change in what tenants are designing. There’s been a lot of discussion on the topic, but I'd say we've seen some slightly less dense furniture layouts. Although pre-COVID, many of our tenants were focused on employee productivity and rarely occupied space to their maximum density. We've seen some increase in phone rooms, breakout rooms, some additional offices being added, but that does not mean that there's a conversion to all built offices. So overall, we 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, media, so it's a good mix of tenants that we are seeing.

Okay, thanks. I guess second question, I guess 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 de minimis 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 product is coming to market?

Sure. Thanks Steve. Our team is busy. That means our new team and our seasoned players like Tom Durels and his property team and John Hogg and his FP&A team. And we're looking at a broad variety of situations. Our focus remains New York City, office retail, and multi-family. We are in conversation with families, many of whom were not so 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, M&A, we spent time on it all. At the same time, I want to make sure that we're not distracted by this bright shiny penny topic, if you will. When we have something, we will let you know and we 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. There's a little bit less of, shall we say, the squirrel that's hunkered down in the middle of the road not knowing to which way to go. We're actually in a process in which people have begun to make moves, come out of their shells, recognize things they have to do, recognize things they would like to do. So, I think it's all kinds of different motivations. And I think we will begin over the next few months to see price discovery come out on different assets as more deals are announced and we'll see more folks come to grips with, are they in a good position with a good runway or do they need help.

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

Look, I think it's highly conjectural at this point. We don't see anything that really evidences there. I think the only thing about which we feel reasonably confident with regard to 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 in order to get any package passed, there is a growing contingent of members of the House of Representatives who have said they will not approve anything without a removal of the cap on state and local tax deduction. While we think it's hard to predict the outcome of any potential decision, 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 I guess 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, we are seeing the bottom, which is activities are or at least, you know, leasing activities are, but tours are up, but you're saying that we have to wait a year to see sort of when the bottom hits. So, what does the path to that look like?

I think that what we see right now Manny, and thank you for the question, is an uneven starting point of data. I wouldn't say that it lays the foundation at this point for a clear picture. What we've seen in prior periods is far more space gets put on the sublet market than has ever sublet. Far more space is discussed to be shared than is ever shared. We also see at a time like this where things are not necessarily restarted entirely. A lot of folks will try to generate business with big incentives, big breaks in rent. Brokers will go out with initial proposals that are radically low. And I think that we don't expect to see a lot of what really sets the base. We’ll see some halting commencement and we’ll get price discovery; we'll get real demand discovery. So, I think a lot of people don't know what's going on until they come back to the office. I would say that a big component, sorry if this goes off of your question, but I think it's something that needs to be addressed for everybody. With regard to this whole future of work, the conversation has really turned. The conversation has turned about the return to office on the basis that the world has started to reopen. I think companies now recognize the difficulties with regard to culture, team, competition, posed not just by work from home, but from the proposed hybrid future. It’s in the New York Times, Wall Street Journal, Economist, New York Post - the problems caused by this theoretical hybrid future. So, I think we understand there are lots of motivations, exhaustion, disconnection, peer to take a day off; you just want to be in the office. There are a lot of things which are occurring which build back into clarity on what people's uses will be, and I think Manny that will build on that base, the foundation as we move forward. So, I think that's where the puck will be, and I really don't think we have a clear vision of that where we don't get any more bad news until the end of the first quarter of '22. Directionally, things have greatly improved and I think we'll continue to see them improve. I think that a lot of reporters will have to learn how to write something which is a negative.

Great, thanks Tony. Maybe you sort of touched on this a little bit in Steve's response to Steve's question, but when you say your teams are busy as it's ever been, over the last three months compared to the entire history of the company. Is that just looking under more rocks? Is that you've had more imbalance or more receptivity to increase or offers you've made? Is that the net is now just wider? Sort of what are the levers you hope to bring in so much more activity or volume or work?

I would say it's three things. The first answer is E, all of the above. So, in every avenue and I go - there are multiple families who have come back to us to discuss issues that they've got that need resolution. They won't all lead to transactions, but people are assessing their situation more actively. Number two, I do believe that we've spent a fair amount of very productive time working with our Board and our Finance Committee so that we get a good process in place. And the final piece is, we've got a full team now and we're underwriting and analyzing a lot of different situations, looking at all the different structures we can put together to make us competitive when we weigh it against our allocation of capital and how we use it. So, hopefully that's helpful to you, but it's really coming from all angles and it's the fact that we're getting back into an expansion mode, where candidly we haven't been as a public company, and we're quite pleased with 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 and I know you don't want to focus too much on transactions until you get something done. But you know Christina, both mentioned that you're looking at office, retail and multifamily opportunities. Number one, are there more opportunities than any one property type than another? And then number two, I guess you guys have experience as a company in office and retail, but multifamily would be a different product. I guess, how do you think about your ability to compete in that space? How do your skills at office and retail translate to acquiring and operating multifamily? Is it just more of a matter of some of the product you're looking at has a multifamily component or you are actually looking at true multifamily?

So, I think I'm going to just focus on the last part of your question because the first part I think is pretty straightforward in my prior response. The multifamily piece, we've done a lot of multifamily historically, and outside of the REIT, my family still owns thousands of apartment properties, not in the New York area. That's part one. They weren't included in the REIT because they weren't in the tri-state region, number one. Number two, we've developed multifamily for sale in New York City before, the Corinthian, the Alexandria. We have turned around assets before, anyone who remembers it was known as the Grand Palais and became the Mondrian, we were the team that made that redo of that failed condo. We’ve done New York City multifamily before, and members of our team who were involved in that and underwriting on that, the property side, the FP&A side, they’re still here. So, we believe we’ve got good experience in that area and we find it interesting as potential additional wheels on our tricycle.

Okay, that’s helpful. And then just shifting to kind of the balance sheets, you guys obviously have an enviable liquidity position, but leverage has been creeping up a little bit over the past several quarters. Christina, can you just talk a little bit about where you guys 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 quite yet?

Yes, not feeling constraint. We are happy with our liquidity position right now; that’s over $550 million of cash and $850 on our new line which has been - now has the maturity in 2025. So, we feel good about that. In addition, we have no debt due until November 2024. So, we feel very good about the flexibility that we have. In terms of net debt to EBITDA, I think I have answered this question before which is, we don’t really look to the exact map level, it’s really about how you are able to access further liquidity. So, the company has always had a relatively conservative stance on the balance sheet. We will continue to manage that responsibly, but the increase in net debt to EBITDA is largely driven by observatory revenues coming down and in this quarter we’re now capturing the full impact of COVID right, between 2Q, 3Q and 4Q of 2020. And we are seeing a ramp up. We’re managing expenses really well. So we feel very comfortable at these levels, not constrained, but we will continue to manage the balance sheet prudently.

I’d just like to add to Christina’s comment, the comment we’ve made before and people may forget, I know you folks are on this call, a lot of different calls to keep track of over today and over the quarters. But yes, we are prepared to take out leverage up, and we're also prepared at the right time to issue more equity. We're also prepared to recognize that there is a virtuous cycle in which we may find ourselves when we commence growth. And we’re also cognizant of the fact that we have bought a lot of stock back at a price which is below where we currently trade, and at some point we could reissue that stock at a higher price and both make a gain on behalf of our investors and increase our liquidity. So, we really feel that we have all of the arrows in the quiver that we might like to have; we feel in a very good spot and very well positioned at this point. If there were one thought that I think we would want to communicate here is, we feel very well positioned right now, we feel comfortable, we’re working very hard. It’s not a place where we’d like to be; we feel very well positioned for the future.

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. Obviously, the pickup in tours is a good kind of future indicator here, but I’m just kind of curious, you guys, your portfolio is always kind of served as a little bit of a value relative to traditional midtown or newer midtown office buildings. Typically, in these situations you see a little bit of a trade-off of space among tenants. I was just curious, number one has your tenant mix shifted at all versus what you have seen in the past? And do you think, because we are hearing from everyone that tours are increasing, how much of an overlap do you think you guys are having relative to the portfolios or maybe the pool of tenants isn’t necessarily increasing; it’s just you’re seeing everyone is seeing the same ones over and over again?

Sure, so I would point to the fact that Zentalis and Burlington were growth tenants, right? And committed to long-term leases, and so we are seeing growth in the market. Probably half of our proposals that are active right now represent tenants that are growing, both Zentalis and Belkin, the law firm that moved to One Grand Central Place; those were trade-ups, meaning they moved up to our property from what I'd call inferior property. So what did they see? They saw what we offer: well-located property next to mass transit in fully redeveloped, modernized buildings with our tenant spaces that will be built in compliance with our state-of-the-art industry-leading standards for healthy buildings, IEQ and energy efficiency, including active bipolarization, MERV-13 and ASHRAE's 62.1 standards. So, those are examples of tenants trading up in the markets to come to our properties, and so we believe we still offer great value propositions for the reasons I just stated. We’re at an affordable price point, we’re well located near mass transit, and we offer fully modernized buildings and newly built tenant spaces, and of course 95% of our portfolio has been redeveloped and we have some 270,000 square feet of tenant space that is built and ready to go. And what’s interesting is, we’ve seen a healthy pickup in activity and interest while proposing the tours for our prebuilt suites, which in the fourth quarter, it was fairly slow in terms of the level of proposals we were exchanging. We’ve seen a big pickup this quarter. Now, I would caution a lot of that activity will translate into activity in the second half of the year.

Great, thanks for the color. And then maybe this is for Tom or Christina, but you guys, the $11 million reduction in OpEx in the first quarter is strong and I know you guys, a lot of that is due to lower utilization, but as we think about going forward, how much of that $11 million is kind of permanent? And as people come back can you guys materially improve the NOI margins at kind of a stabilized point versus maybe historic levels?

So, first I’d say that echoing what Tom had said in his opening remarks that we are actively looking at ways to improve our operational efficiency, so that we can lock in permanent savings. The reductions made to date represent aggressively managing our expenses. Certainly, the bulk of it was due to reduced physical occupancy related to COVID-19, but we have completed our redevelopment work which allows us to reduce permanently certain expenses and certainly keep a cap on the growth of expenses as we get into next year. So we do expect to lock in a portion of those. We haven’t given a specific number, but I think our best mark will be 2019, which is the last year of full building utilization, and I think that we’re going to see some improvement off of those numbers.

Great, thanks guys.

Thank you. Our next questions come from the line of Jamie Feldman with the 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 smallest tenant leasing activity versus larger? You were able to keep your percent lease flat which is impressive. It looks like you had a couple of buildings that had occupancy dip a little bit; just curious if there’s any kind of read-through for small tenants versus larger tenants based on what you’re seeing?

Sure, so, Jamie, the increase in and decrease in occupancy that you noted from the prior quarter was really due to known moveouts, which we had communicated last quarter. The most significant was the termination of full-floor tenants for 40,000 square feet which we have already released to ClearView; we announced last quarter, whose lease will commence by the end of this year. The most important thing is that our forecast of 300,000 square feet of tenant vacates in 2021 has not changed significantly from prior forecasts, and we have 305,000 square feet of signed leases that we expect will commence by year-end. So, I think from an occupancy standpoint, we’re in very good shape. On the small tenant activity, as I just mentioned, we’ve seen a big pickup in activity and level of interest both on tours and proposals being exchanged for our small suites that are fully built to comply with standards for IEQ and sustainability. We offer turnkey suites, which means before our price increase, we will offer the suite fully furnished, fully wired, and provide move coordination. Comparing to where we were last quarter, I'd say we were probably about three-quarters or 80% of our pre-COVID level, which represents a big increase from last quarter.

Okay, thank you. And then you had said giving net effect there was down about 10% to 15%. Can you break that out by face rents, concessions, free rent, and TIs?

Well first, I would say that every deal is unique and really depends on the space, condition, the location, the tenant credit, and other factors. For example, the Burlington expansions, the Zentalis and Belkin leases were all turnkey deals with leases that ranged from eleven to sixteen years. Generally, there's been more negotiation around concessions, but one of those deals, we gave maybe a rent discount of $2 to $3 per square foot compared to pre-COVID levels combined with three to four months of additional rent and a few dollars more in TI. Whereas the others, we held rent flat and gave more on concession. So, it's really a mixed bag and it depends on the individual deal and the negotiation. I would point out that our average lease cost per lease year for this quarter for TIs and commissions was about just under $9.5 per square foot, which is right in line with our leasing costs for all of 2019. And of course we had a weighted average lease term this quarter of 10 years and that compares favorably with the last two to three quarters.

Okay, thank you. And then I guess, I know you've talked a lot about the investment activity, but just to be clear, would you consider assets outside of New York City or NED level transactions if they did have assets outside of New York City?

We appreciate that, Jamie. I may not always find the right words. I've used that term before. Our primary focus is on Manhattan and the greater New York metropolitan area. To expand the business, we need to consider all types of transactions.

Okay, is there, it's funny because I was going to use the same word but I didn’t want to take it out of your mouth, you've been using that for a long time. I mean is there a regional limit? I mean, would you look at national stuff or west of the Mississippi River or not necessarily?

I honestly wasn't aware there was anything beyond the Hudson River; is there something out there? All joking aside, the last thing we want to do is create speculation. It's important for our stakeholders, and as responsible investors, we need to consider all logical options for capital allocation. We look forward to discussing something more concrete rather than speculation, and we'll be more communicative when we have updates.

Thanks for that. I'd like to discuss the suburbs. The portfolio seems to have been fairly stable in terms of occupancy rates. I noticed there was some activity at 10 Bank Street. Would you say there's been any improvement or has it remained quite steady?

Well Jamie, remember we have a 63,000 square feet with Berkeley Insurance that will commence later this year, and that comes on the heels of a fairly large earlier moveout by a tenant at Metro Center. So, that will help our occupancy numbers. We have seen a pickup in tours like in Manhattan and that pickup since the start of the year brings us to tour volume today at about pre-COVID levels, which I think is a positive sign. Still, I think that that's going to translate into activity in the second half of the year. So, it is a bit early on that. Downtown White Plains, I think is generally performing well. Downtown CBD Stamford is where we see a good amount of tour activity. Up in Norwalk, I'd say it's slower, but we are exchanging proposals with some fairly large tenants, because we have a large block of about 80,000 to 90,000 square feet at our MerrittView property. And so, we'll see how that translates into real activity later in the year.

Okay. I mean, is there anything in behavior during the pandemic that would make you want to grow transit-oriented to the suburbs?

We like our portfolio, yes we like our portfolio. We think we're very well located near the mass transit, and we did recently complete an upgrade of all of our common areas including gyms, dining, coffee lounge, lobbies and outdoor areas, which we got a little bit more work to do at Metro Center, but we're really well positioned, and I think we're focused on leasing up our vacant space there.

Yes and I would put it this way. I think it is improvement to note what you didn’t ask is, have we seen a big flow of tenants in that tour group out of New York City, and the answer is no, we haven't.

A handful.

Yes, a handful and some leases done, smaller leases under 10,000 square feet which were reported.

Okay, all right thanks for all the color.

Thank you. As a reminder, oh sorry. There being no further questions, we're going to finish up here. We have one, we have no further questions, so what we will do is go to one last comment and then get you all to 1 o'clock. I do again want to complement our great team without them, ESRT is nothing, number one. Number two, please do review our sustainability report. Don’t do it today but do it when you've got a moment. It really will show you what's more than the 100% of renewable wind energy, what is more than healthy buildings. You get to see where the puck will be when you read our first annual sustainability report. And finally, we want to make sure that you understand that our forward-looking statements, our plans around but the observatory and we turn to business for discussion purposes only to help you with your models. They are not guidance nor are they guarantees. We look forward to a chance to meet with you many at the upcoming May Conference Virtual, and we look forward to seeing your all return to office; we're healthy, we're vaccinated and we're in a very safe place to come and visit. So say hello, look for a person, thanks so much. 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.