Malkin Holdings, the company that owns The Empire State Building and an additional 5 million square feet of office and retail space in New York City and its immediate boroughs filed to go public a few weeks ago under the company name Empire State Realty Trust (ESB). Their filing does not give an indication as to the valuation of the company, making it difficult, nay impossible, for investors to evaluate whether or not to invest in the company. With that said, I would still like to examine one specific detail of the filing, which I think investors should take into consideration if and when the company completes its offering. Aside from the issue at hand in this analysis, along the way I will make some general comments as to the current environment of the New York City office space market.
In page 7 of the S-11 filing Empire State's management lists the vacancy rates and rents in its particular buildings. While reading the filing I felt surprised by how much of the company's future rides on the success of its efforts to turn around the Empire State Building from a building filled with small, poor credit tenants, into a strong institutional building.
This turnaround effort has two parts:
- A full modernization of the building, which management estimates will cost about $320 million, or $100 per square foot
Clearing the building of smaller low quality tenants, to make room for larger tenants.
This second part has caused The Empire State Building to have a huge vacancy rate. In the filing, Empire State's management writes that The Empire State Building currently has about 875,000 square feet of vacant space, nearly half of the total portfolio vacancy.
Therefore, in order to realize an upside on the stock, management must execute its strategy of attracting high quality tenants effectively. The way I see it, The Empire State Building must overcome a few major hurdles to effectively execute this strategy. Chief among them - the new developments coming on line in the next few years both in its current sub-market in New York City, and in other areas of New York City. Secondly, management must contend with the general trends in the New York City market, which seem to point to a lack of demand for large blocks of space.
These new developments pose a threat to Empire State because they offer tenants new, high quality, modern, and energy efficient space, which developers will build to suit for a large tenant. Though this space might run higher than the Empire State Building, companies in general will spend more money on their spaces for two reasons:
The more expensive spaces tend to allow for a more efficient layout, shaving off costs in different areas.
Employees make up a company's most expensive and important asset. Companies will spend more money on space because it doesn't make up a huge expense for them, as opposed to employee costs. And secondly they will attract better employees if they have nicer space.
The Empire State Building's location - Penn Plaza district along 34th Street - puts it into direct competition against three major developments, undertaken by three major developers that have either broken ground already, or will break ground once they sign a major tenant. Moving from New York City's East side to West side, the Empire State Building faces the following competition:
15 Penn Plaza - Vornado (VNO): 2 million square feet of space
Manhattan West -- Brookfield Office Properties (BPO): 4 million square feet of space
Hudson Yards - Related Companies: 6 million square feet of space.
All of these developments share the common high quality attributes for office space listed above, and will attract interest from tenants that Empire State would like to have in its buildings.
I will now focus on Vornado's development at 15 Penn Plaza and I will use that as a jumping-off point to talk about what I see as the second problem Empire State faces: A lack of demand.
15 Penn Plaza
Vornado has plans to build a major, 2 million square foot office building on 34th Street, less than 900 feet away from The Empire State Building on the site of the current Hotel Pennsylvania. Empire State launched a major campaign to stop this development, which it lost handily in a community board vote. Vornado does not have plans to start construction anytime soon. In fact, recent reports say Vornado intends to fully renovate the hotel and upgrade it in order to achieve higher rates and occupancy.
This could give Empire State some breathing room from a major competitor, but I would argue against that theory. The very fact that Vornado has put the brakes on this major project, which it has spent a major amount of time, money and effort on, shows the slowing demand in the institutional tenant space. Boston Properties (BXP) echoed this sentiment in its most recent conference call. On the call, Boston Properties noted that it will have a major vacancy of 145,000 square feet in the New York City market this year at 399 Park Avenue. In management's comments they noted how they wished they could lease the whole space to one tenant, but in reality they might have to break up the space into smaller spaces, because of the lack of demand for large blocks of space.
The upshot of this analysis shows how Empire State really has two major threats.
Other developers competing for similar quality tenants
The lack of demand in this market
World Trade Center - An Empire State Building Alternative
An easy argument many will make when trying to rebut my theory will run something like this. True, Empire State faces stiff competition from nearby developments, but the new buildings will command much higher rents, allowing Empire State to attract low-end and government style tenants. And although I disagree with this for the majority of corporate tenants, as noted above, I think the argument holds water for government tenants. The problem with this line of thinking lies in the fact that Empire State will face competition in luring those tenants away from the World Trade Center. When Tower 1 of the World Trade Center opens, the General Services Administration (GSA) will occupy 415,000 square feet of space. Other potential government tenants - the New York State Office of General Services (OGS), had committed to the tower, but recently pulled out. Both the GSA, which will take space in the tower, and the OGS, which had a commitment to take space, had political motivations for taking the space. Government agencies want the World Trade Center to get rebuilt, as it will cement for any politician a major win. This political wildcard will prove extremely difficult for Empire State to overcome when trying to lure tenants into its buildings, especially considering that The World Trade Center project still has about 10 million square feet of office space approved and ready to build when a tenant decides to sign a lease.
Besides the three major Midtown developments and the World Trade Center, the Empire State Building has to contend with 3.5 million square feet of new office space coming to the market from the likes of Boston Properties and other major developers.
These smaller developments can get underway with a smaller commitment from a major tenant, in contrast with the larger projects mentioned above that require a large commitment from a tenant. The fact that Empire State has to fight on both of these fronts against new developments, in addition to the waning demand from large blocks of space, could prove very challenging.
The total for all the new developments listed above will rise above 20 million square feet, all of which will directly compete with Empire State. I did not talk about the many other institutional-style buildings with large blocks of space coming onto the market, which will also pose a tremendous challenge to Empire State.
In a word, Empire State has made a valiant attempt at transforming itself from a low grade building, into a truly world class building. But in my opinion, that effort will fall short both because of new developments, and lack of demand. We need look no further than Times Square, where a brand new 1.1 million square foot building, 11 Times Square, still sits nearly 50% vacant, waiting for an institutional tenant to take a large block of space. Empire State will not only face this space challenge, but also fierce competition from competitors who offer a better, higher quality product.