Empire State Realty Trust, Inc. (NYSE:ESRT) Q2 2023 Earnings Call Transcript July 27, 2023

Operator: Greeting and welcome to the Empire State Realty Trust Second Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It’s now my pleasure to introduce Heather Houston, Senior Vice President, Chief Counsel, Corporate and Secretary. Thank you. You may begin.

Heather Houston: Good afternoon. Thank you for joining us today for Empire State Realty Trust second quarter 2023 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 esrtreit.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, expense, financial results and proposed transactions and events. As a reminder, forward-looking statements represent management’s current estimates.

They are subject to risks and uncertainties, 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. During today’s call, we will discuss certain non-GAAP financial measures, such as FFO, modified and core FFO, NOI, same-store property cash NOI, EBITDA and adjusted EBITDA, which we believe are meaningful in evaluating the Company’s performance. The definitions and reconciliations of these measures to the most directly comparable GAAP measures are included in the earnings release and the supplemental package, each available on the Company’s website.

Now I will turn the call over to Tony Malkin, our Chairman, President and Chief Executive Officer.

Tony Malkin: Thanks Heather, and good afternoon to everyone. We are pleased to report another solid quarter and first half of the year. We put points on the board with strong leasing and Observatory performance. Our balance sheet positioning remains best-in-class. We have a positive outlook for the second half of 2023. Our focus on modernization, amenities, energy efficiency, indoor environmental quality, and an industry-leading balance sheet make us a destination in the flight to quality. ESRT is a New York City focused landlord with four diverse drivers of value. When you walk the busy streets of New York now it is clear how resilient this city really is and we are primed to take advantage of New York City’s continued recovery.

People want to live here, people want to visit here, and people want to work here. This is a city that draws a regular migration of young, highly educated, hungry, and diverse talent to work in person and learn. New York is a top three city for return to office post-pandemic, according to Placer.ai, top companies offered talent a place to gather in person, to plan, mentor, learn, build, execute together, and move forward through uncertain times. And they want to be in office buildings like ours, which serve as talent attraction and retention tools. We leased more than 336,000 square feet in this quarter, and those leases were at double-digit positive leasing spreads. Our Manhattan leased office percentage is up to 91.6% and reflects an increase of 90 basis points sequentially and 330 basis points year-over-year.

ESRT offers a trophy experience in pre-war assets. ESRT properties are fully modernized and amenitized. More than 95% of our office space has been stripped to the studs and redeveloped. Flight to quality is not as simple as new versus old. ESRT’s properties performed consistently as measured on an occupancy percentage, leased percentage and total leasing volume basis because we had made the investment to make our assets future ready. Our leasing progress meets the performance of newly built Class A office properties. We offer compelling value propositions and well located, fully modernized, energy efficient, and amenitized healthy buildings at our attractive price points. Importantly, we are also a landlord who has the balance sheet to stand behind its commitments and obligations with an economically accessible winning portfolio.

This makes a big difference in today’s environment and helps set us apart as a landlord. We have always said that our goal is to get the best deals in good times, get the deals in challenged times, and draw consistent leasing volumes through cycles. We know what we have to do and we are absolutely focused. The Observatory continues to perform well. For the second year in a row, our Observatory experience was ranked the number one attraction in the United States by TripAdvisor. In the first half of the year, Observatory NOI exceeded comparable 2019 levels by 4% with 71% of the admissions relative to 2019 levels. We continue to manage expenses, drive top line growth, and provide visitors with unmatched customer experience. The Empire State Building Observatory is the authentic New York City experience.

Our Observatory’s cash flows are reliable as demonstrated on Slide 17 of our investor presentation. ESRT’s balance sheet is clean and the capital structure is simple. We have the lowest leverage amongst all New York City office REITs and have neither near-term debt maturities nor floating rate debt exposure. ESRT owns 100% of our office assets with no complex joint venture structures and that allows for great flexibility and optionality for future financing and capitalization. Tenants look to partner with a financially stable landlord who will maintain high quality standards at their assets. We can allocate capital as we think best, be it capital recycling, new acquisitions, or share repurchases. Our industry and environmental stewardship and healthy building performance matters more and more each year to tenants, landlords, and shareholders.

For our tenants, this was put to the test this quarter when the Canadian wildfires greatly impacted the air quality in New York City, IEQ testing during the Canadian Wildfire event in early June, met Empire State Realty Trust’s rigorous indoor environmental standards, which are aligned with LEED version 4.1 and WELL version 2 standards. Our sustainability work at ESRT isn’t an add-on to our platform. It is integrated within every decision we make. We uphold our values and adhere to the highest standards in reporting. I encourage you all to read our 2022 sustainability report that was released in the second quarter during Earth Day Week, which contains full details on our recent accomplishments, new investments and return based goals. As we look ahead, we see opportunities created through the market and credit disruptions and we will manage through them.

ESRT is prepared to act on opportunities which arise from the disruption. Our priorities are unchanged, lease space, sell tickets to the Observatory, manage the balance sheet, and achieve sustainability goals. In short, put points on the board. These actions together enhance our shareholder value. We believe in New York City and we offer four ways to play it office, the Empire State Building observatory, retail and multifamily. New York City is resilient and Empire State Realty Trust is future ready and well positioned to drive value for our shareholders in 2023. Tom and Christina will provide more detail on our progress and how we plan to accomplish these goals in the balance of the year. Tom?

Tom Durels: Thanks, Tony and good afternoon, everyone. We had another strong quarter with 336,000 square feet of total leasing at 10% positive mark-to-market rent spreads for our office and retail portfolio. Year-to-date, we’ve leased a total of 538,000 square feet. This represents our sixth consecutive quarter in which we achieved positive absorption based upon leased percentage for our office and retail portfolio and our eighth straight quarter with positive mark-to-market lease spreads in our Manhattan office portfolio. Our leasing results demonstrate that our fully modernized buildings located in Midtown with convenient access to mass transit, quality amenities, best-in-class sustainability and indoor environmental quality offered at an accessible price point continues to attract quality tenants.

We increased our Manhattan office leased percentage to 91.6% in the second quarter, which increased 90 basis points compared to last quarter is up 330 basis points compared to a year ago and has increased to 460 basis points since the end of 2021. In the second quarter, we signed over 336,000 square feet of leases, which include 308,000 square feet in our Manhattan office properties where we achieved our highest rent levels to date in two of our properties. The average starting rent in all Manhattan office lease assigned was $64.48 per square foot with an average lease term of 7.9 years and seven months of free rent with a tenant improvement allowance of $64.58 per square foot. 18,000 square feet of lease signed in our greater New York Metropolitan office properties and 10,000 square feet in our retail portfolio where we continue to bring food, wellness and services to our campus properties to support the demand from growing office users.

Notable lease assigned in the second quarter include a full floor 11 year lease for 27,000 square feet at the Empire State Building with Capco, a global management and technology consulting company. And 11 year lease for 25,000 square feet at the Empire State Building with Skanska, a world leading project development and construction group and ESB tenants since 2008. And 11 year 12,000 square feet leased at One Grand Central Place with Breakthru Beverage, a leading North American distributor of luxury wines and spirits. A 30 year 29,000 square feet leased at 1333 Broadway with Rising Ground, a non-for-profit organization. Leases for 18 pre-built office suites and earlier this quarter, we were happy to announce that Flagstar assumed the entirety of Signature Bank’s 313,000 square foot lease at 1400 Broadway.

As shown on Page 6 of our supplemental, we have $59 million in incremental initial cash revenue from signed leases not commenced and free rent burn-off. We remain well positioned to increase our lease percentage by year-end since we proactively managed our rent roll, executed early renewals and expect only about 191,000 square feet of tenants to vacate by the end of 2023, which will be offset by any new leases that are signed before year end. We have a healthy pipeline of lease activity and have demonstrated our ability to lease space. We have invested nearly $1 billion into our assets to create healthy, fully modernized buildings. Our tenant spaces are newly built with our leading standards for IEQ and sustainability. We are adding to our robust in-building and campus amenities.

All our assets are centrally located near mass transit. As an industry leader, we offer our tenants the latest advancements in sustainability and indoor environmental quality. Our strong balance sheet allows us to compete in today’s environment and gives tenants and brokers confidence that we will deliver on our promises and we have an exceptional dedicated team that delivers a high level of service to our tenants. Within our multi-family portfolio the average occupancy of 97.4% reflect strong market fundamentals and we are underway with property improvements that will enhance future performance. Our recently acquired 298 Mulberry continues to experience strong demand that exceeds our expectations. Once again, we had another solid quarter with 336,000 square feet of total office and retail leasing at strong positive mark-to-market spreads.

We increased our Manhattan office portfolio lease percentage by 90 basis points over the prior quarter and by 330 basis points from a year ago to reach 91.6%. We are well positioned to further increase our lease percentage in the second half of 2023, and we continue to see strong performance in our growing multi-family portfolio. And now I’ll turn the call over to Christina. Christina?

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Christina Chiu: Thanks, Tom. Our focus is to put points on the board. For the second quarter of 2023, we reported core FFO of $69 million or $0.26 per diluted share, which is up 17% year-over-year, excluding lease termination fees. As previously announced in the second quarter of 2023, we reversed $5.8 million of the $6.4 million straight line reserve taken in the first quarter of 2023 as a result of the Flagstar lease assumption at 1400 Broadway. This had a positive $0.02 impact on our second quarter FFO result. Same-store property and cash NOI excluding lease termination fees increase 1.1% year-over-year, primarily driven by an increase in cash rental revenue and timing of tenant expense reimbursements, partially offset by increases in property operating expenses and real estate taxes.

In the second quarter, the observatory generated NOI of $24.3 million, an increase of 26% year-over-year. This represents NOI recapture of 101% as compared to the same period in 2019. Observatory expense was $8.7 million in the second quarter. We have the balance sheet flexibility these uncertain times demand to generate shareholder value. As of June 30, 2023, the company had total liquidity of $1.2 billion, which was comprised of $315 million of cash and $850 million of undrawn capacity on a revolving credit facility. At quarter end, the company had net debt at share of $2.3 billion with a weighted average interest rate of 3.9% and a weighted average term to maturity of 5.9 years. Our ratio of net debt to adjusted EBITDA was well below peer averages of 5.8x.

We have no floating rate debt exposure, a well laddered maturity schedule and no debt maturity until November 2024 when a $78 million mortgage matures. We can choose to recycle our balance sheet, pursue investment opportunities that are additive to our New York City focused portfolio and repurchase our shares. In the second quarter and through July 25, 2023, the company repurchased 7.4 million of its common stock at a weighted average price of $6.09 per share. This brings the cumulative amount repurchased to $293.7 million at a weighted average price of $8.18 per share, which represents approximately 12% of total shares outstanding as of March 5, 2020, the date our share buyback program began. In the second quarter, we completed the sale of our 500 Mamaroneck office property for $53 million and the proceeds were partially utilized in a reverse 1031 tax deferral transaction into the 298 Mulberry Residential acquisition that was executed in December 2022.

We continue to evaluate opportunities to recycle our balance sheet and invest in new assets and remain prudent in our underwriting. And now onto our outlook for the balance of the year. We’ve adjusted our 2023 guidance as follows. Our 2023 FFO guidance range is increased to $0.83 to $0.86 per fully diluted share. The increase reflects the $0.02 positive impact from the reversal of the straight line reserve previously taken in the first quarter related to Signature Bank and the subsequent assumption of the lease at 1400 Broadway by Flagstar in the second quarter and updated our full year same-store cash NOI outlook by 100 basis points. As a reminder, our team actively managed expenses amid COVID and significantly reduced operating expenses in 2020 and 2021 compared to 2019.

Expenses and building utilization will normalize this year. With that said, full year property operating expenses are still expected to be approximately 5% below 2019 levels, which reflect some permanent cost savings and efficiencies we achieved from pre-COVID levels. Additionally, the year-over-year expense increases are partially offset by tenant expense reimbursements. The increase in our 2023 same-store our cash NOI guidance range is primarily due to modestly higher cash rental revenue and later [ph] property operating expense increases relative to our initial expectations. Our same-store commercial occupancy guidance is unchanged at 85% to 87%. The leasing pipeline remains on track. As we stated last quarter, our range factors in some conservatism in terms of the timing of lease commencements.

For the observatory, we continue to expect 2023 NOI to be approximately $88 million to $96 million up from $75 million in 2022. Our NOI guidance assumes observatory expenses at approximately $9 million per quarter on average for 2023. In summary, the company continues to manage our balance sheet prudently and strategically and have strong liquidity to take advantage of attractive investment opportunities that may emerge in this period of uncertainty and capital dislocation. We continued share buybacks, albeit at a more measured pace in the second quarter. In aggregate, we’ve repurchased 12% of total shares outstanding since the inception of our buyback program. Our commercial portfolio is now 86.8% occupied and 90.3% leased, and we continue to benefit from tenants demand for our high quality assets and the unique value proposition and balance sheet strength that we offer as a landlord.

Our observatory recovery continues with good momentum to start the year, and our fourth leg of growth multifamily continues to perform well and adds to the resiliency of ESRTs cash flows. And with that, I will now turn the call back to the operator for the Q&A session. Operator?

Q&A Session

Operator: Thank you. [Operator Instructions] Our first questions come from the line of Steve Sakwa with Evercore ISI. Please proceed with your questions.

Steve Sakwa: Thanks. Good afternoon. Tom, I was wondering if you could just provide a little bit more color and detail around the pipeline. Maybe help size the pipeline for us where it is today versus say, three months to six months ago and the types of tenants that you’re seeing and maybe the size of tenants that you’re seeing today?

Tom Durels: Sure, Steve. Well, first of all, our solid quarter demonstrates that there is tenant demand for our well located amenitized quality product and tenants have confidence in our ability to execute and deliver on our promises. That said, we’ve got a healthy pipeline. We’ve had some 20 or so leases in negotiation for about 200,000 square feet, mostly in our Manhattan office properties for both new renewal relocations and early extension deals and comprised of both pre-built and full floors. And then we have another 20 or so proposals that we’re trading paper on for really several 100,000 square feet. I’d say 14 of those deals range between 10,000 square feet to 70,000 square feet and then over a dozen proposals for pre-built that variety of sizes that add up to about a 100,000 square feet.

So, overall a pretty good healthy pipeline. The tenant types that we’re seeing are consistent with this past quarter and prior quarters, which represent a variety of industries that include professional services, nonprofit, consumer products some tech and fire sector tenants. So good diverse mix of tenants. So overall, we feel pretty good about where we’re at in the quarter ahead.

Steve Sakwa: Okay, thanks. Excuse me. And then on, just in the follow up, Christina, I guess on the share buyback, I don’t know if the activity level was muted, just that was sort of share price driven if you were looking at some other capital deployment opportunities, just I guess with the rise in the stock price, I guess how sensitive are you to kind of share buybacks, and I guess how do you sort of evaluate, when to say no, how to kind of lean into that or sort of lean out from the buyback?

Christina Chiu: Yes. So we continue to believe in buybacks and it’s a strategic part of our capital allocation that’s evident from the overall volume that we’ve done $280 [ph] million for it since we started. As we’ve always mentioned, the pace can vary from period to period for a number of factors, including fluctuations in share price. But beyond that, because it’s still at discounted levels, right? So beyond that, it’s also 10b5-1 periods and other factors. And as a final reminder, we do value buybacks, but we also look at operating runway and liquidity as well as the chance to evaluate and take advantage of opportunities that may arise in the marketplace. And we have been very active on capital recycling. So those are all of our priorities, buybacks are on the list. We’ve done it in volume, but certainly the pace could vary.

Operator: Thank you. Our next questions come from the line of Michael Griffin with Citi. Please proceed with your questions.

Michael Griffin: Great, thanks. Maybe to follow up on that, on that leasing question first. I’m curious if you’ve noticed if more tenants are quicker about making decisions when it comes to leasing. I mean, it seems like the positive commentary we’ve heard about more tenants coming into the market. Is there less uncertainty around them taking space than there was over the last few quarters?

Tom Durels: I’d say that what we’re seeing is, tenants that are more committed to making a decision, a lot fewer tire kickers out there. And that’s [indiscernible] by really our conversion rates from what we see strong conversion from two to actual deals. So, as I look at all of those prospects that we’re speaking with right now, we feel very good about, they are committed to landing somewhere. And so it’s good for the overall marketing and good for us.

Michael Griffin: Great. Thanks. And then just on capital allocation priorities, you touched on the various food groups, the multifamily, the office, the share buybacks. I’m just curious with some distress we’ve seen in the office market recently; could there be an opportunity out there to potentially acquire an asset and maybe reposition it consistent with your current strategy?

Tony Malkin: So Griff, Tony here. Thanks. As I tell our younger colleagues, we really view this as 1989 to 1992 for the real estate industry. Bottom line, when you raise interest rates to levels which are more historical and you’ve gone through a period where people have borrowed as much as they could afford at low interest rates. You’re going to have a more than a few borrowers heads go through the windshield. And the benefit to us in our current position is that we have an opportunity both because of our execution at a high level and because of our balance sheet to take advantage of this. And we do believe that there are opportunities we know very clearly and we understand very clearly at what we rent, what our costs are to rent.

More importantly though, we understand what it costs to modernize, amenitize, make energy efficient and execute on an indoor environmental quality the type of asset that we operate and that we can deliver at an attractive price. So we have our bogey, we know the locations where we want to be, we know the floor plates we want, we know the types of tenants who are interested and we are definitely interested at the right price in office.

Michael Griffin: Great. That’s it for me. Thanks for the time.

Operator: Thank you. Our next questions come from the line of Camille Bonnel with Bank of America. Please proceed with your questions.