Empire State Realty Trust's (ESRT) CEO Anthony Malkin on Q3 2017 Results - Earnings Call Transcript

Empire State Realty Trust, Inc. (NYSE:ESRT) Q3 2017 Results Earnings Conference Call November 1, 2017 8:30 AM ET

Executives

Thomas Keltner, Jr. - Executive Vice President, General Counsel and Secretary

John Kessler - President, Chief Operating Officer

Thomas Durels - Executive Vice President, Director of Leasing and Operations

David Karp - Executive Vice President, Chief Financial Officer

Anthony Malkin - Chairman and Chief Executive Officer

Analysts

James Feldman - Bank of America Merrill Lynch

Craig Mailman - KeyBanc Capital Markets

John Guinee - Stifel Nicolaus & Company, Inc.

Rob Simone - Evercore ISI

John Kim - BMO Capital Markets

Blaine Heck - Wells Fargo Securities, LLC

Operator

Greetings and welcome to the Empire State Realty Trust third quarter 2017 earnings call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Thomas Keltner, General Counsel at Empire State Realty Trust. Please go ahead.

Thomas Keltner, Jr.

Good morning. Thank you for joining us today for Empire State Realty Trust third quarter 2017 earnings conference call. In addition to the press release distributed last evening, a quarterly supplemental package with further detail on our results has been 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 certain 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, 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.

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.

The 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 John Kessler, President and Chief Operating Officer.

John Kessler

Good morning. We are delighted to welcome you to our third quarter 2017 earnings conference call. Empire State Realty Trust is a pure-play Manhattan and Greater New York Metro area office and retail portfolio that offers a unique opportunity to grow income as we continue to redevelop and lease our properties at market rents and bring occupancies to market levels.

Since inception, we have delivered and we expect to continue to deliver our embedded de-risked growth.

During the third quarter, we continued to execute on our focused strategy and delivered strong results. We saw significant tenant demand for our value price point and well-located quality buildings as we signed over 487,000 square feet of leases during the quarter.

This activity includes a three-floor office lease with Fragomen at 1400 Broadway for 108,000 feet, our largest transaction in the quarter and a three and three-quarters floor lease with ASCAP at 250 West 57th Street for 85,000 feet.

We continue to deliver significant upside in rents, one of our four drivers of our internal embedded growth, achieving average leasing spreads of 46.1% on our new Manhattan office leases and 27.7% on all new and renewal leases across our entire portfolio.

Additionally, our Observatory continues to be resilient and achieved a 3.1% year-over-year increase in revenue in the third quarter and a 3.4% year-over-year increase in revenue through the third quarter on a year-to-date basis.

We continue to execute on our previously-announced capital project to enhance the experience of office and retail tenants and Observatory visitors at the Empire State building.

Over the past two years, we have provided regular updates on our maturing broadcast leases and licenses, including an anticipated reduction in related revenues.

We previously disclosed renewed lease and license agreements with TV broadcasters, Univision, ABC and WPIX; and radio broadcasters, iHeart, CBS Radio, MS [ph], Spanish Broadcast Systems, and New York Public Radio.

With Fox Television's third quarter decision not to renew their lease and license, we have now finished materially these renewal discussions. The renewal or non-renewal of broadcast leases and licenses has not had, nor is expected to have, a material impact on our financial results.

The revenue impact from renewals and non-renewals will phase-in over the coming quarters. We look forward to recapturing approximately 25,000 square feet of former broadcast equipment room spaces on the 77th through 79th tower floors to convert to office use and just under 14,000 square feet of space above the 80th floor for Observatory-related uses.

We believe we will continue to drive growth and unlock value as we redevelop and re-lease our space at attractive spreads and we believe our portfolio and strategy can outperform regardless of market conditions.

During the quarter, we refinanced our revolving credit facility and term loan at attractive rates, extended our revolving credit facility maturity, and improved our financial covenants.

With our highly liquid and low-levered balance sheet, we're well-positioned for additional opportunities going forward.

Our prepared comments this morning will be fairly brief. Tom Durels, our Executive Vice President and Director of Leasing and Operations, will provide an update on our portfolio, and David Karp, our Executive Vice President and Chief Financial Officer, will then review financial results in more detail and discuss our balance sheet. After that, our team, including our Chairman and CEO, Tony Malkin, are here to answer your questions.

I'll now turn the call over to Tom Durels. Tom?

Thomas Durels

Thanks, John. Good morning, folks. On today's call, I'm going to provide you with an update on our four key growth drivers, review our leasing activity in the second quarter, give an overview of our current and future space availabilities and discuss some of our recent redevelopment work.

As you know from our investor day in March 2015, we set forth our four key growth drivers from our existing portfolio, representing revenue growth of $90 to $100 million over the following five to six years.

Since January 2015, when we exclude contribution to NOI growth from the Observatory, and adjusted for the mid-2014 acquisitions of 1400 Broadway and 111 West 33rd Street, we have delivered $69 million in cash NOI growth in just two years and nine months. This is net of the loss of income from the vacancies we create through our redevelopment and re-leasing program.

Our third quarter numbers reflect further progress on our four growth drivers, which are, one, upside from signed leases not commenced of $12.3 million and burn-off of free rent of $30.3 million, which together total approximately $43 million of growth.

Two, lease-up of developed vacant office space of $27 million. Three, the mark-to-market on our expiring Manhattan office leases of $18 million. And, four, the mark-to-market and lease-up of available retail space of $10 million.

Based on these updated numbers, we estimate these drivers will contribute approximately $98 million of growth over the next five to six years as of September 30, 2017. It's relative to our trailing 12-month cash NOI of $378 million.

Remember that we calculate these numbers based on our view of the current market for starting rent, without consideration for potential increases in future starting rents.

As we stated in the past, we expect that our occupancy will fluctuate from quarter-to-quarter as we vacate and consolidate spaces in order to redevelop and re-lease those spaces at higher rents to better tenants.

There is a timing lag between the move-outs of existing tenants and when new leases commence. Overall downtime is generally 9 to 24 months following the last date of occupancy by prior tenant to allow for redevelopment and lease-up.

In the third quarter, we signed 34 new and renewal leases, totaling approximately 488,000 square feet. This included approximately 315,000 square feet in our Manhattan office properties and 173,000 square feet in our greater New York Metropolitan properties.

Significant office leases signed during the quarter include the international law firm Fragomen for 108,000 square feet of 1400 Broadway; ASCAP for approximately 85,000 square feet at 250 West 57th Street; Priceline's Agoda brand for an expansion to a 27,000-square-foot full floor at the Empire State Building; and Odyssey Reinsurance for an early renewal of 87,000 square feet at First Stamford Place.

The leases with Fragomen and ASCAP involve the lease up of both vacant space and space that is currently occupied by tenants paying below-market rents that we had planned to vacate for redevelopment.

As a result, we will be intentionally vacating approximately 68,000 square feet. And the net positive absorption is approximately 125,000 square feet for these two leases.

The net result is already included in the $12.3 million growth driver for signed leases not commenced, which I stated earlier.

We expect that the lease with ASCAP will commence in May of 2018 and Fragomen will commence March 2019. The commencement date for both for GAAP reporting will occur approximately 6 to 12 months later.

And subsequent to quarter-end, we signed office leases with Universal Music Group for a full floor of 26,000 square feet at 250 West 57th Street and Madison Square Garden Ventures for a full floor of over 10,000 square feet at 111 West 33rd Street.

Clearly, our redevelopment work at 111 West 33rd Street and 250 West 57th Street has resulted in excellent leasing results. The newly complete lobbies and street fronts look fantastic. And tenants and brokers clearly agree as evidenced by the recently concluded leases with ASCAP, Universal and MSG.

At quarter-end, our total portfolio was 89.8% occupied, which is up 60 basis points from the second quarter. And including signed leases that have not yet commenced, the total portfolio leased percentage was up 40 basis points from the first quarter at 91.7% leased.

At our flagship property, the Empire State Building, we were up 120 basis points from the second quarter of 2017 to 93.3% occupied. And including our signed leases not yet commenced, our leased percentage was 93.5%, up 110 basis points from last quarter.

As a result of our redevelopment strategy, we continue to capture healthy rental growth spreads. During the third quarter, rental rates on new and renewal leases across our entire portfolio were 27.7% higher on a cash basis compared to prior escalated rents.

And in our Manhattan office properties, we signed new leases at positive rent spreads of 46.1%. remember, leasing spreads will vary by quarter depending on the prior fully escalated rents.

Our tenant installation cost for the quarter was $72.92 per square foot for the total portfolio. This number will also vary by quarter depending upon the mix of spaces leased, including white box, prebuilt, first-generation and second-generation space and ratio of new versus renewal leases.

Throughout our total portfolio, as of September 30, we had 1,032,000 square feet of vacancy, against which we have 191,000 square feet of signed leases not commenced, for net total of 841,000 square feet of unleased space, which is comprised of Manhattan office vacancy of 642,000 square feet, retail vacancy of 42,000 square feet, and Greater New York Metropolitan office vacancy of 157,000 square feet.

Of the 642,000 square feet of unleased Manhattan office space, approximately 447,000 square feet is consolidated and redeveloped, prebuilt and white box space ready for lease-up.

Approximately 121,000 square feet is being held off market until it can be consolidated and the balance of our vacant spaces are either planned for redevelopment or storage.

We expect to vacate 176,000 square feet in our Manhattan office portfolio by year-end. And with in-place fully escalated rents of $46.74 per square foot, we expect to re-lease this space at much higher rents.

As a reminder, as of September 30, we have signed leases that have not yet commenced and free rent burn-off, which will add $43 million in cash NOI growth by March 2019.

Within our Manhattan office portfolio, we currently have available nine full floors ranging in size from 8500 square feet to our largest single floor at 42,000 square feet. The nine floors total 172,000 square feet, including three floors at 111 West 33rd Street, two floors at 250 West 57th Street, and one floor each at the Empire State Building, 1350 Broadway, 1400 Broadway and One Grand Central Place.

As I previously mentioned, the new lobbies and street front at 111 West 33rd and 250 West 57th look fantastic and we've already had excellent leasing success at both these properties.

Turning to our retail business, our street retail portfolio is both 94.1% occupied and leased and is located in high traffic areas with excellent submarkets.

The strong execution and leasing results delivered by our team has positioned us well. We have leased all our retail space on 57th Street.

On Broadway, where we have brought in an interesting mix of quality food choices and retail to support our growing office tenant population, and the entire 89,000 square feet at 112 West 34th Street, where we previously reported a mark-to-market aggregate rent increase of nearly $19 million, and we have only 8% of our retail spaces expiring in the next two years.

Overall, I feel really good about our leasing pipeline and I remain very confident in our team's ongoing ability to execute, as they have clearly demonstrated in the past, and deliver on our four key growth drivers.

We continue to see steady demand at our properties, which offer prospective tenants an attractive combination of location and amenities at a value price point. We continue to lease up our vacant space and execute on our proven strategy to consolidate, vacate and deliver redeveloped space in order to lease to new, better credit tenants at higher rents, increased NOI and improved shareholder value.

Now, I will turn the call over David Karp. David?

David Karp

Thanks, Tom. And good morning, everyone. As you may notice, my voice is strained as I am a bit under the weather. In fact, my colleagues have all chosen to sit at the far end of the conference table, out of the range of my coughing.

In any event, I'll start with a review of our financial performance, revisit Tom's discussion of our four drivers, and follow with an update on our Observatory operations and balance sheet.

For the third quarter, we reported core FFO of $77.5 million or $0.26 per diluted share. Cash NOI was $101.3 million, up 8.1% from the prior-year period.

For the nine months ended September 30, 2017, core FFO was $212 million or $0.71 per diluted share. Cash NOI was $281.4 million, up 8.3% from the prior-year period.

As of January 1, 2015, we have delivered approximately $69 million in cash NOI growth from our office and retail leasing performance. In addition, we have delivered approximately $17 million in NOI growth from our Observatory performance.

Finally, we estimate our updated four key growth drivers would deliver approximately $98 million of revenue growth over the next five to six years, relative to our training 12-month cash NOI of $378 million.

For the past two quarters, we've provided additional disclosure with our signed leases not commenced and we've added the impact of leases that have commenced, but are in their free rent period.

As of September 30, 2017, unexpired free rent adds $30 million to this driver. We now include, on page five of our supplemental, a five-year schedule for the burn-off of the free rent associated with these leases.

This additional data point, which we will now provide on a quarterly basis, further supports the cash NOI growth potential we have and we believe this will assist the investment community to better model our business.

As you recall, in the first quarter, we disclosed that we adopted a change in our revenue recognition practices. As of January 1, 2017, for leases where the tenant constructs tenant improvements, in which we share the funding obligation, we began to recognize rental revenue at the earlier of cash rent commencement or completion of tenant improvements.

Previously, we had started rental revenue recognition when the lease commenced. This change is consistent with the practice of our peers that have made similar modifications over the past years.

This new accounting practice resulted in approximately $1.1 million less revenue for the third quarter 2017 compared to the practice in place for the prior-year period.

Turning to Observatory operations. Revenue for the third quarter 2017 grew 3.1% to $39.3 million from $38.1 million in the prior-year period.

Third quarter performance was relatively stable due to continued revenue improvement despite lower visitation, unfavorable weather conditions and higher expenses.

NOI was $30.7 million, down 0.3% from $30.8 million in the third quarter 2016.

The Observatory hosted approximately 1.28 million visitors in the third quarter 2017, a decrease of 4.8% compared to the third quarter 2016. In the third quarter 2017, there were 14 bad weather days compared to 10 bad weather days in the third quarter 2016.

As disclosed last quarter, we no longer are breaking bad weather days into week and weekend days. Instead, we're now providing an estimate of the impact of bad weather days on overall attendance based upon compiled Observatory historical data.

We're happy to discuss this new metric through which we do bad weather days based upon historical data.

For the third quarter, we made that bad weather resulted in approximately 35,000 to 40,000 net fewer visitors than in the prior-year period.

We define a bad weather day as one in which the top of the Empire State Building is obscured for more than 50% of the day.

For the nine months ended September 30, 2017, the Observatory hosted approximately 3.04 million visitors, down 4.6% compared to 3.18 million in the prior-year period.

Observatory revenue was $94.2 million, up 3.4%, compared to $91.1 million in the prior-year period, while net operating income grew 2.7% to $71.1 million from the prior-year period.

For the nine months ended September 30, 2017, there were 51 bad weather days compared to 31 bad weather days in the prior-year period. As a reminder, we always look at the Observatory's results on a holistic annual basis.

Turning to our balance sheet, our strong joint venture free and flexible balance sheet, including significant cash on hand, remains a competitive advantage for us in any market environment.

During the quarter, we successfully refinanced our $1.1 billion revolving credit facility and our $265 million term loan.

We were very pleased to have accomplished several important objectives. First, we lowered our borrowing costs with initial interest rates on the new facility of LIBOR plus 120 basis points for the term loan and LIBOR plus 110 basis points for any drawn portion of the revolving credit facility, a savings of 40 and 5 basis points respectively from the prior facilities.

In addition, the initial annual revolving credit facility fee decreased from 20 basis points to 15 basis points.

Second, we significantly lengthened the maturity of our revolving credit facility to August 2021 versus the prior credit facility which was due to mature in January 2019.

Third, we added flexibility to the financial covenants associated with the credit facility.

In connection with the refinancing, we recognized a non-cash loss in the quarter of $2.2 million on the early extinguishment of the prior debt.

At September 30, 2017, we had total debt outstanding of approximately $1.6 billion, all fixed rate, with a weighted average interest rate of 4.05% and weighted average term to maturity of 6.2 years.

At the end of the third quarter, we had no outstanding balance on our revolver and $432 million in cash and cash equivalents.

Our leverage ratio reflected by consolidated net debt to total market capitalization was 15.7% and our consolidated net debt to EBITDA was 3.3 times.

I'll now update you on our redemption requests. For operating partnership units, our lock-up period expired one year after issuance, which was October 7, 2014 for units issued in the IPO and July 15, 2015 for units issued on the acquisition of 112 West 34th Street and 1400 Broadway.

Upon such expiration, holders of such operating partnership units could have their holdings redeemed for Class A shares which are listed and traded on the NYSE.

As of September 30, 2017, we've had conversions from operating partnership units in class B common shares to Class A common shares totaling 34 million shares, or approximately $698 million at the closing share price $20.54 on September 29, 2017. This represents a 42% increase in the number of Class A shares since our IPO.

Finally, our Board of Directors approved a quarterly dividend of $0.105 per share for the third quarter of 2017. This dividend was paid on September 29 to shareholders of record on September 15.

With that, I would like to open up the call for your questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Jamie Feldman with Bank of America. Please proceed with your question.

James Feldman

Great. Thank you and good morning. I was hoping to focus on the Observatory for a minute. I guess, just starting out, so your visitors were down, your revenue was up and your NOI was down. Can you talk about the expense load? And why it was up year-over-year and whether that's going to continue on here and what your margins might look like?

David Karp

Good morning, Jamie. It's David. Just as a reminder, we look at the Observatory on a holistic annual basis. And we note that our results can vary quarter to quarter.

So, if you look at the Observatory expenses on a trailing 12-month basis, that would be a good approximation for more normalized run rate in general.

The specific fourth quarter of 2016 would give a good idea of a fourth-quarter run rate. The actual cost for the third quarter reflects a combination of higher payroll estimates and timing pertaining to certain technology and repair and maintenance costs.

James Feldman

Okay. So, I guess, the question is, is any of that one-time? It sounds like it's seasonal, but is any of it one-time that goes away or is that – does some of that – is there a new expense load that's going to continue on?

David Karp

There is not a new expense load per se. Again, there is variation from quarter to quarter. As you know, there's seasonality. There's expenses that relate to a certain season, staffing, payroll, et cetera. So, there will be variation quarter to quarter. But if you're asking, is there anything new, a significant material addition to our expenses that's going to be long-term, I would say no.

James Feldman

Okay. And then, can you talk more about the calculation of the bad weather days that you mentioned in your prepared remarks?

David Karp

Yes. What we're doing now is we're taking a look at the impact of bad weather on what we're able – what we'll lose and what we're able to recapture. So, for example, if we have a bad weather day and we lose visitors on that day, we may be able to make that up on the following day if the weather clears.

So, what we've done is we've examined the differences year-over-year for the same days when a bad weather day occurs and we're looking at the net impact of that bad weather and we're also adjusting for anything other than bad weather that might be affecting it. So, we're looking at a trend for the quarter, backing out what might have been a change in that day, but for the bad weather, and then we're comparing that with the overall change to determine what the true impact of the bad weather was.

Anthony Malkin

So, I'll jump in here, Jamie. First of all, we don't think David has bronchitis. We think he has the hantavirus. But we're all in the same room. So, if we're all gone end of week, you'll know what it was.

But second of all – Tony here – just to put it in context, if we have a bad weather day on a Friday of a holiday weekend and you have a 17,000-person-day historically on the Thursday and a 18,000-person-day historically on a Saturday, and that Friday would've historically been an 18,000-person day, you simply cannot make up the visitors lost either on the prior day or on the next day because there's no capacity in the Observatory.

In addition, if you have two bad weather days in a row, you lose the tourists again by both capacity and the fact that certain people just – based on shorter stays in New York – they are not here for as many days. So, you can't recoup it.

We look at all these statistics historically going back and we've been doing a more refined calculation. We used to just report bad weather days, weekends and weekdays. Then, of course, in the middle of August this year, when we had much higher bad weather pertaining to – I think if we had six in August of 2017 and we had one in 2016. The fact is it doesn't matter in August if it's a weekend day or a weekday. Those are peak periods.

So, the analysis that we're giving is trying to be more helpful to you folks and putting your model and understanding what is the general market trend versus what's impacted by the weather.

James Feldman

Okay, thank you. And then, Tom, there's been some concerns about just slower leasing volumes in midtown south. Can you talk about whether you're seeing any of that in your portfolio?

And then, just the final question, I guess, for Tony would be thoughts on the Lord & Taylor deal with WeWork and then moving to the neighborhood. But, I guess, starting with Tom, if you could answer.

Thomas Durels

Sure, Jamie. Look, I feel very good about our portfolio and our activity. I want to remind you that we did over 1,000,000 square feet of leasing year-to-date. 488,000 square feet of leasing in the third quarter, of which 277,000 square feet was new Manhattan office leasing. I think the stat speaks for itself in terms of the strength of our portfolio and our submarkets.

That leasing stat included deals of Fragomen for 108,000 square feet and 85,000 square foot lease with ASCAP, a full-floor lease with Agoda, a division of Priceline in Empire State Building. Post-closing of the third quarter, we signed full-floor deals with Universal at 250 West 57th Street, a full-floor deal with Madison Square Garden at 111 West 33rd Street.

Look, I'm thrilled with the activity that we've had at 111 West 33rd and 250 West 57th Street as we finalize the lobby work at both properties. The lobbies, the storefronts and the entrances look fantastic. We actually even started our elevator cabs at both of those properties. We've received fantastic comments back from touring brokers and tenants and the results I think speak for themselves.

I'm incredibly thrilled with the lease Fragomen at 1400 Broadway. It's a fantastic result. I think it validates the appeal of the Times Square south neighborhood as an attractive, central office location with great access to mass transit and the ongoing improvement to the streetscape.

We just opened the new Maison Kayser eatery, which looks fantastic and they're doing a robust business. We think it's a great amenity to the neighborhood and to our office tenants.

Wolfgang is going to open up in early 2018. There's other food providers that have opened up in the area.

Going into the fourth quarter, we have activity in deal flow throughout the portfolio. We're consistently strong. So, overall, I feel really good about our product pipeline and our submarket.

On WeWork – maybe John will jump in here as well. But, look, we've commented before that – we've said in the past we will not lease space to WeWork. Not only do we prefer the direct relationships with the end users of our space, but in our view, WeWork's model makes it difficult, if not impossible, to have a secure building and their transient users tend to beat up on the buildings. We don't think we should underwrite the risk of their variety of short-term rental income streams when we have great tenant to whom we can lease directly.

John Kessler

Yeah. And, Jamie, it's John here. Just from a capital markets perspective, I'd comment that we think the transaction reflects that Hudson Bay clearly needed to raise some capital and WeWork was looking for a new location for their headquarters. And based on the price and the size of that building, certainly looks like a very strong price per square foot, something in the 1200 per square foot range. And speaks to the strength of the capital market continuing and our submarkets.

Anthony Malkin

And the only thing I'll add to that, Jamie, is that – I think that Tom and John have very accurately summarized our view around all different aspects of WeWork and the capital markets. But I would also point out that, with this transaction, there's a sale in 1440 coming up, which we looked. We're getting a pretty good view that we think that the overall market for third-party transactions that are being done at arms' length would indicate that we're doing much better keeping our capital dry at this point relative to what we're doing with returns in our own portfolio.

And other than that, it looks good for our market area to see more people coming into that that gap between 42nd Street and 34th Street on Fifth Avenue.

James Feldman

Okay, great. That's all very helpful. Thank you.

Operator

Thank you. Our next question comes from the line of Craig Mailman with KeyBanc Capital Markets. Please proceed with your question.

Craig Mailman

Good morning, guys. Maybe just a quick clarification for Tom on ASCAP and Fragomen. I think you said the GAAP commences six months later than the cash. Did I hear that correctly?

Thomas Durels

Later than the lease commences per the terms of those leases. Based on GAAP recognition, we will recognize the commencement of those leases upon completion of the work or upon burn-off of free rent. So, that's going to occur, we estimate, 6 to 12 months following the commencement of those leases.

John Kessler

Craig, this goes back to what we discussed earlier is the change in revenue recognition approach. So, whereas prior to the new revenue recognition, we would start from a GAAP basis recognizing that revenue upon the commencement – the legal commencement of the lease. Now, we're recognizing that GAAP revenue upon especially the completion of the tenant improvements.

Craig Mailman

Right. So, the May 2018 and March 2019, those are the legal commencements. And then cash and GAAP would commence after that?

John Kessler

GAAP would definitely commence afterwards. The cash commencement is at the expiration of the rent-free period.

Craig Mailman

Okay. I can follow up off-line on that one. And then, Tom, maybe following up on Jamie's question about WeWork and asking it a different way. These kind of co-working tenants are moving up from just the smaller freelance guys to kind of slightly bigger tenants. Are you guys seeing any competition for the prebuilds that you have in the neighborhood or expect to see any competition kind of on that side of the spectrum?

Thomas Durels

The answer is no. Like I said before, we really prefer the direct relationships with the end users of our space. And whether it be a WeWork, similar type tenant, for the reasons I stated, issues concerning security, physical abuse to the buildings, our preference is to lease directly with those tenants that with whom we have a relationship and that have term.

We have a steady amount of activity and pipeline on our prebuilt that range from generally 3000 square feet on up to, on the high side, of 12,000 square feet. And we're getting excellent term and excellent tenants to lease those spaces.

Anthony Malkin

I'd just add to that, Craig. There are all sorts of philosophical approaches one could take as to what do we think about the co-working environment. We're not going to spend a lot of time on that. The valuation of WeWork being more than most office REITs, we're not going to spend a lot of time on that. But I would say very simply that our business model is trying to deliver predictable results with the lowest discount possible on the basis of the predictability of revenue coming down the pike. And, really, we don't need to go further than that.

If WeWork is successful, that's great. They are going to continue to occupy space. If WeWork is not successful, we won't be exposed to their lack of success.

I will say anecdotally that I am aware from our day-to-day activity that the co-working environment, in our view, is finding its way into large companies and that that feel, if you will, is being incorporated into tenant fit-outs and build-outs throughout our entire portfolio. And anybody who is taking a look around and gone on any of our tours and seem any of the spaces in our buildings, seen our own offices, this is all I think quite positive and it's ongoing and it can be incorporated by large companies as well as by small ones.

But as far as WeWork specifically, our view of this is, interesting. We know it's out there. It hasn't impacted our business and we don't intend to let it impact our business.

Craig Mailman

That's helpful. And then, Tony, you kind of mentioned 1440 Broadway here. It sounds like you guys looked and passed. If you could comment on that.

But then, also, there's concerns in the market about shallower bidding pools and pressure on asset values. You guys have been patient here. Are you feeling like there's a better opportunity set today than there was 6 to 12 months ago to put some of your capital to work?

John Kessler

Hey, Craig. It's John here. We did look at 1440 certainly right in our submarket and we're always going to look at assets that are in our neighborhoods. And as Tony had commented and as you have heard us comment with respect to other potential acquisitions, when we look at it relative to the returns that we're getting on our redevelopment, just did not look attractive to us. But doesn't mean that we're not studying it.

And then, as it relates to the state of the market in general, clearly, transaction activity is down. But as we look at – again, look at where pricing and returns are, we continue to not see an opportunity relative – that's attractive relative to their reinvestment in our portfolio.

Anthony Malkin

I just might add two comments. One, as Yogi Bear said, when we come to a fork in the road, we will take it. And, look, we don't see a fork in the road for us on this transaction, nothing really inspiring or motivating.

Number two, we've been very clear about what our program is going to be going forward and on what we're focusing. And if we were going to diverge from that, we would absolutely signal that to you folks. We've always placed a high premium on setting out what we're going to do and sticking to it.

And then, finally, with regard to the capital markets and the depth of the capital markets, no, I don't know whether or not the statistics are adequately compiled to give an accurate picture of what's going on, but I do know that, gosh, we're not the best sources of knowing every bidding procedure that's out there.

Cushman & Wakefield, Jones Lang LaSalle, different folks can provide different information. I will say that, on those situations which we have looked, they don't cause us to find a fork in the road.

So, from our perspective, we're still focused on what we're focused.

Craig Mailman

Okay, got you. And you had talked a couple of quarters ago about some higher-level M&A transactions. Are those still kicking around? Or have those kind of fallen by the wayside?

Anthony Malkin

We maintain a lot of ongoing discussions and those are with a variety of different folks. I think we have to be careful. When we talk about M&A – because M&A is always the hottest song being played at the bar and everybody wants to get out on the dance floor and dance to that song. We don't want that to overshadow our day-to-day execution. But it's absolutely, from our perspective, a benefit to look at more complicated things where we can, with ourselves and with others with whom we might do business, unlock value with our capabilities, our balance sheet and our portfolio, in combination with others.

And I do believe there's a risk in drawing too much attention and too much light to that subject, but we are also – I can confirm, we just continue these discussions.

Craig Mailman

Okay. Thank you, guys.

Operator

Thank you. Our next question comes from the line of John Guinee with Stifel. Please proceed with your question.

John Guinee

Great. A bunch of quick questions. First, probably David Karp, if you can still speak, quarter-over-quarter since 3Q 2016, looks like operating expenses are up around 7% and tax is 9%, maybe vice versa. Were there any one-time items there or is that just what one should expect owning Manhattan office? Property expense is up 7%, tax is up 9%.

David Karp

John, I think on the operating expenses, at least sequentially, from Q2 –

John Guinee

Not sequentially. 3Q 2016 to 3Q 2017.

David Karp

Okay. So, the majority of those property expense increases is due to higher payroll and benefits and higher workers' comp as well as some higher security costs, understanding we did have some major lobby renovations ongoing during that time period. And as a result, incurred a little bit higher expense in terms of security.

John Guinee

How about tax? Tax is at 9% up.

David Karp

Yeah, we're not happy about that either. As you know, in New York, the tax assessments are based upon reported rentals and operating performance of the properties. Fortunately, our properties have been improving in their rent rolls and their operating performance. And as a consequence, that will drive operating expenses through real estate tax increases.

John Guinee

Okay. Second, your G&A is pushing $50 million, which is a huge number for a 10 million square-foot office REIT. How much of that G&A is attributable to the Observatory?

David Karp

We really haven't broken out our G&A specific to the Observatory. We do have the operating expenses reported separately for the Observatory performance.

But with respect to our G&A, as we look at it, and we look at it as a percentage of revenue, we feel very comfortable where we are in relation to our peers.

John Guinee

Third, you've been running about $60 million to $68 million of restricted cash for the last four or five quarters. What exactly is that?

David Karp

Those will mostly be tenant security deposits.

John Guinee

Okay, got you. And then, probably Tom, you said you freed up 25,000 square feet on floor 77 to 79 of the Observatory. Good window lines, good elevator access, good floor depths, good office space or is there a different use expected?

Thomas Durels

These are prime floors. Great views. They at the top of our stack for office floors. The 79th floor is our highest office floor. So, clearly, the views are stellar. And we expect to get top-of-the-market rents for Empire State Building on those floors.

John Guinee

Okay. And then, Tony, what day is the stair run in February?

Anthony Malkin

We're talking, I think, February 4, I believe, is that they – sorry, February 2 of February 4. But one way or the other, you'll definitely be getting an invitation. Everyone should know there will be, without a doubt, an investor and analyst flight. We're hoping to have more than John Guinee in that flight. So, anybody who would like to go, we will have medics available. By the way, anybody who would like can go online and look for Guillermo from the Jimmy Kimmel Show who when Jimmy Kimmel was in Brooklyn, he sent Guillermo up the Empire State Building stairs at 6 AM. There is a fantastic cameo appearance by Tom Durels welcoming Guillermo to the Empire State Building. Well, Tom complains that his best comedy was left on the cutting room floor. We still think he did a great job.

John Guinee

Great, thank you.

Operator

Thank you. Our next question comes from the line of Rob Simone with Evercore ISI. Please proceed with your question.

Rob Simone

Hey, guys. Good morning. Thanks a lot for taking the question. I was wondering if first you guys could comment or provide an update how inbound tourist traffic has been trending or kind of what your experience is just with all that's going on in the world right now.

And then, secondly, if you're able to thus far in Q4, just given the – as an example, the weather we had this past week and how are the bad weather days trending year-over-year?

Anthony Malkin

Well, I'll take the second part first. The year-over-year weather – it's really very simple. We've had a much, much higher number of bad weather days in 2017 versus 2016. And, again, in August alone, we had six bad weather days in 2017 versus one in 2016. And this is unfortunate because, by our calculations, we can make up a bad weather day when it's a typical 18,000 to 20,000-person day. We've just lost that. There's nothing we can do. So, that's problematic.

Traditional inbound travel to the US, including Europe, is down. You can get a further explanation of the perceived reasons for this from hospitality companies. We still have the trend of more people taking much shorter visits to New York City. They have fewer days during which they can visit us. We are very comfortable with our competitive position inasmuch as we are seeing an outperformance of the Empire State Building relative to other attractions in New York City. We are certainly tremendously outperforming One World Trade Center.

And I think that we can look to the fact that those people that we have coming through have continued to be attracted to and get a high degree of satisfaction from their visit in spite of our revised pricing programs, which are subtle, which are really very well researched. We started announcing this several quarters ago, how we were deploying lessons learned in our pricing.

I would think that it's most important to note that we don't project on the Observatory when we look at our gains that we've made in NOI from the operation of Empire State Realty Trust. We do break out the retail and the office from the Observatory. When we look at our four drivers of growth, the Observatory is not included in those four drivers of growth.

But from our perspective, look, we believe the tourist market has been a little soft. The weather has been lousy. And that's life.

I will say that we do believe, holistically, looking at things over time, you have better bad weather years than others. And last year, frankly, we had much, much better weather and particularly during peak periods. And if this year is soft in that regard, well, there's hope that next year, we'll have about a positive experience relative to this year's experience.

Rob Simone

Thanks, Tony. That's really helpful. And then maybe just one final question. You guys had said last quarter that you would update the Street on the progression of the capital investment in the Observatory entrance, kind of as you go through the process. Are there any changes to your timing or updates you can provide there?

Thomas Durels

Rob, this is Tom. There's really no changing to our timing on what we had stated on the last quarterly call. We are focused on the first phase, which is relocating the entrance to the 34th Street center of the building, which will provide a separate, dedicated entrance for Observatory visitors. It will eliminate Observatory visitors from entering the Fifth Avenue lobby, and thereby reducing Observatory traffic in the Fifth Avenue lobby by more than 50%. We're still there by opening that portion of the lobby to office tenants and their visitors, which we think is a major plus. We think by locating the entrance to the 34th Street side, we'll vastly enhance the value of all of our retail space on 34th Street.

And then, beyond that, the overall program will enhance the Observatory visitor experience and increase the revenue per capita.

I would like to point out that there's going to be no disruption to the Observatory operations or the visitor experience during the project. On timing-wise, we would be looking at some time in second quarter for opening that 34th Street entrance.

And then, of course, at that time, we'll [indiscernible] to see it for themselves.

David Karp

And, Rob, it's David. Just as an update on the actual spend, just a reminder, if you look at page 15 of our supplemental, we're now breaking out the spend for the observatory capital project. And in this past quarter, that's reported at $13.4 million.

Rob Simone

Great, guys. Thanks a lot. Talk soon.

Operator

Thank you. Our next question comes from the line of John Kim with BMO Capital Markets. Please proceed with your question.

John Kim

Thanks. Your portfolio occupancy has been trending higher over the last few quarters and I think it's at a historical high. Do you have a target occupancy for 2018 and whether not it will trend closer to your lease figure?

Thomas Durels

John, this is Tom. What we have always said is that our occupancy will bump around from time to time as basically on our strategy to intentionally vacate space, consolidate our redevelopment, so we can re-lease it higher rents to better tenant.

What I can tell you is that, for the balance of 2017, where we have about 250,000 square feet rolling throughout the entire portfolio, about 243,000 square feet, nearly all of that is in our Manhattan office space.

We do expect to vacate approximately 176,000 square feet by year-end, within our Manhattan office portfolio. As a reminder, the fully escalated rent on that is just under $47 per square foot, so that we expect that – as that feeds our pipeline for redeveloped space, we will re-lease that at much higher rents.

And then, in 2018, I will provide updates as we get into 2018, but we have about 780,000 square feet expiring in 2018 and only about 586,000 square feet expires in our Manhattan office portfolio.

John Kim

And of that 2018, do you know of any known move-outs?

Thomas Durels

Well, as of right now, I think based upon intentional vacates, bear in mind, some of that relates to the leasing that we've already done with, say, Fragomen and ASCAP. We expect to vacate approximately 357,000 square feet through all of 2018 in our Manhattan office portfolio.

John Kim

And, Tom, there's been a discussion I think on densification and how this may have ended for the tenant as far as squeezing as many employees per square foot. Your tenant base is a little bit more diversified. I'm wondering if you have a view on this trend?

Thomas Durels

I do. I think that what we see with our tenants is that it's more a focus on redesigning and re-creating office environments for the greatest productivity for that tenant. We don't see a trend with our tenant to densify just for the sake of densification, to squeeze more bodies to let square feet. It's all about creating a company culture, an environment that enhances our tenants, employee productivity and their bottom line overall economic performance. And what we see is our tenants using the office space very much as our tool to enhance their company and productivity. So, it's not about densification. It's about building office environments that are smartly designed to enhance company culture and bottom line performance.

John Kim

Can you share with us what tenants are underwriting today as far as average space per employee?

Thomas Durels

We're seeing a pretty wide range between just under 200 square foot per person to around 250 square foot per person. We have some tenants that have gone as high as 300, 400 feet per person on certain floors. So, it really runs the gamut. But I think that you can think of a pretty good bogey in that 200 to 250 square feet person.

Anthony Malkin

So, to be clear, when you look at other – and by the way, not all the scoffing at this point is David. He's infected three of the people in the room. We'll see how many are still alive when we're done with the call.

But when you look at the types of tenants that have really been driving benching and super high density per employee, getting down to 125 to 130 square feet per tenant, what you might find interesting is to talk to a Gensler, to talk to a TBG, to talk to some of the architects in there to understand what they're designing to.

What we understand is two things. One, there's been big push back to this intense densification and that the number is now bubbling up. People have got to as low as they thought they could go and they're finding out the employees do not like it and they don't want it and they don't want to work in that kind of environment.

Number two, we don't rent to these tenants who have this incredible density. You can pretty much equate super high density with lesser credit quality tenants, with people who are more on a startup environment, with co-working environments like a WeWork. And the tenants with whom we work – ha, a Freudian slip there. Tenants with whom we do business, we end up with folks who are building better spaces. They are trying to attract higher quality employees, attract and retain higher-quality employees. They have longer-term business models. And many of them would be like our office.

For those of you who have been to our office, we do have, what I think a lot of people would call, benching. But we have a tremendous number of meeting rooms, eating rooms, we've got co-working spaces where people can gather and meet. There is not, in our portfolio, this intense densification. And we think people are rejecting it. Employees are rejecting it.

John Kim

Okay. And then, a question on the Observatory. And as far as you discussed the decline in international tourists, The Times recently wrote an article on this and they attributed this to the rhetoric under the current administration. Does this concern you at all as far as something that could linger for the next few years or do you view this as more of an aberration?

Anthony Malkin

We really take our cue from people like the American Travel Association. I think there are folks out there in the hospitality business who spend a heck of a lot more time looking at it.

I think that New York City is a capital of the world. Tourism is a major component of it. The Empire State Building is a very important draw within that. And with our redo of our observatory, we're going to be an even more important draw.

So, from all of those perspectives, I can tell we've enjoyed the competition, the opportunity to compete and our competitive position, and I'm going to leave it to people – just like we tell you – we don't give a lot on market statistics because there are so many other firms who put the stuff out on the office and on the retail side.

From our perspective, on the tourist side, there are other people out there who are way more involved than we are. We just deal with what we get.

John Kim

But as far as increasing in advertising budget, targeting domestic visitors, is that something you have considered?

Anthony Malkin

No. Really, most of our advertising, as people would think about it, is in co-branding the building with different brands around the world where we get the building – which is already the iconic image, the world's most famous building.

What we do here is, in our investor deck, which is available on our website, of what we do with the co-branding, tremendous amount is involved with social media, with digital media. Very little advertising dollars actually spent.

Operator

Thank you. Our final question comes from the line of Blaine Heck with Wells Fargo. Please proceed with your question.

Blaine Heck

Thanks for taking the question. Just a couple for Tom. Concessions for you guys were down a little bit this quarter, which was great. But from what we're hearing, it seems like generally, in the city, they're rising. Just wondering if you can comment on whether you guys are seeing any need to offer higher TIs or free rent recently to attract tenants?

Thomas Durels

Blaine, as I commented in the past, the number that we report on concessions is going to vary by quarter depending upon the mix of spaces leased, including white box, prebuilt, first-generation and second-generation space, and then, of course, the ratio of new versus renewal leases. I think that where we've seen, in some cases, an increase in concession, particularly on TI has been offset by higher rent.

If you look at this quarter, where 88% of our Manhattan office leasing, or 277,000 square feet out of 315,000, was for new leases, which is an incredibly positive stat. Logically, we had a higher reported leasing cost in this quarter compared to prior quarters. However, if we compare it to say that third quarter of 2016, where only 79% of our total leasing volume was for new releases, the all-in leasing cost for TI and commission was comparable.

So, we're seeing improvements in rents, particularly in tower floors of 250, 111, Empire State Building, One Grand Central. Improvement in rents in that is offsetting concessions. On full-floor deals, we're generally seeing TIs in the range of $80 to $90 per square foot.

On some smaller spaces, we get to, say, 20,000 square feet and under, often we're looking at a full built, which is basically the equivalent of a prebuilt.

Blaine Heck

Okay. That's helpful. And then, on the Empire State Building office portion, it looks like 2020 is a big year for expiration. Is the majority of that space pre-renovation? If so – and I know it's early – but is there any way to pull some of that forward to kind of accelerate the timeline of getting all that space repositioned?

Thomas Durels

Well, we've done that successfully throughout our portfolio on the space at Empire State Building specifically. We're really not forecasting recapturing that particular space early. We do have one full floor available now. We have an inventory of prebuilt offer little over 60,000 square feet of prebuilt inventory. We will get possession of a full floor next year and we'll be delivering some more prebuilt product next year.

But at this point in time, I don't see recapturing that 2020 lease expiration space earlier than the current expiration.

Blaine Heck

All right. Thanks, guys.

Thomas Durels

You bet.

Operator

Thank you. There are no further questions.

Anthony Malkin

Yeah. That wraps up our call this morning. Thank you very much all for your time. We look forward to reporting our next quarter and we always welcome visits in an incoming. So, please, our doors are always open. Thanks very much, folks.

Operator

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.