Empire State: A Quality Play On New York
Summary
- We have covered SL Green Realty Corp. and Vornado previously.
- Today, we add a third New York-focused REIT.
- This one is currently the cheapest among the three by a few metrics and is certainly putting its money where its mouth is.
- The bull case though comes down to answers to two major questions.
- I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
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We wrote about SL Green Realty Corp. (SLG), an office REIT based in Manhattan, in the recent past. While we liked it, we gave it a neutral rating as we preferred the more conservative Vornado Realty Trust (VNO). For those still wanting to dip their toes in SLG, we suggested an entry via Cash Secured Puts.
Today we will dive into another New York-based office and retail REIT, Empire State Realty Trust (NYSE:ESRT). This REIT holds predominantly office space in Manhattan and the surrounding metropolitan areas. It also has a small amount of retail exposure.
Source: Q3-2021 Earnings Presentation
Both sub sectors are having the distinction of being in the top 2 of the least loved real estate since the start of the pandemic and understandably so. The occupancy has been trending down with the September 2020 numbers lower than the comparable quarter in 2019.
Source: Q3-2021 Earnings Release
A crown jewel in their portfolio is the globally known Empire State Building. This one not only took a hit to the office space but also the tourist revenue which came from the observatory due to the periodic COVID waves and the resultant restrictions on international travel.
Source: Q3-2021 Earnings Presentation
There are a few visible silver linings though. First, they have a healthy balance sheet.
Source: Q3-2021 Earnings Presentation
Second, they have a varied tenant base.
Source: Q3-2021 Earnings Presentation
And (no, not world peace) 100% of their 10.1 million rentable square feet is powered by renewable wind energy.
Having taken a big picture look at this REIT, let's dive deeper and see where it stands vis a vis its peers in our books.
Valuation Within The Group
While ESRT has a unique portfolio and asset set, it is primarily driven by its office holdings and that is the peer group we should look at. As it stands, within that sector, only one REIT today is at a premium to what analysts think the liquidation value or NAV is. That one is Alexandria Real Estate Equities (ARE), a fully valued, 56X FFO multiple sporting REIT. Outside that, analyst NAV numbers don't carry any sway in this sector. Still, a good way to look at relative valuations is to see how far from consensus NAV the current price is. ESRT is at the very low end of the group with a 40% discount to consensus NAV of about $16.00/share (S&P Global) and in line with Office Properties Income Trust (OPI). Now we have covered OPI previously and we are talking about apples and orangutans when we try and make a comparison between the two. The asset base is very different (OPI has mainly single tenant properties) and OPI is also externally managed. VNO and SLG though, are right in line with ESRT in terms of property quality and management and both trade at less distressed discounts (about 30%) to estimated NAV. ESRT is less leveraged than those two when we try and look at what a normalized EBITDA would be in a post pandemic world. Its debt maturity profile is also exceptional in relation to its own EBITDA.
Source: Q3-2021 Earnings Presentation
ESRT is also paying a very minimal dividend currently and while that may not please the existing shareholders, it does create an exceptional liquidity situation.
On a 2023 FFO multiple basis, ESRT trades in line with SLG and about 3 multiples cheaper than VNO. So at a baseline level, assuming things return to some sort of normalcy, ESRT is the cheapest of the group (adjusted for debt).
Empire State Building Valuation & Buybacks
One big fear that is prevalent here is the valuation of the Empire State Building housing the observatory. Ever since the inauguration of "The Edge" in 2020, there has been concern whether those revenues will ever come back to 100%. While competition concerns are genuine, we think the pie is big enough for both when things normalize. Certainly KKR would not have bought a controlling stake in the Edge if the view was that this was going to be an all-out war for revenues.
Inaugurated in 2020, Edge is a giant terrace open to the public and located 335 meters high, which is higher than the tip of the aerial of the Eiffel Tower (324 m).
It is part of a 395 m high building, located in the new Hudson Yards neighborhood, built over railroad tracks, in western Manhattan.
According to the Traded website, KKR has acquired a 75% stake in the observatory, part of the floor of which is made of glass and through which visitors can see the bottom of the tower.
Source: Bat Information
But the bull thesis does depend a bit on the valuation you assign here. On ESRT the difference in valuing the Empire State Building between $500 million and $1.5 billion (yes we think the latter number is very probable), is 40% of the equity market capitalization. With its low expenses and high NOI margins, it does become a rather interesting inflation hedge for the right buyer. Even beyond the Empire State Building valuation, there is a lot of subjectivity to the ending equity pie. Small tweaks of your numbers and cap rates could send your NAV calculation to $10 or $20.
While all REITs like to market the idea that their stocks are worth more than the market price, it is nice to see a company actually step up in the right way.
In the third quarter and through October 26, 2021, the company repurchased $6.5 million of its common stock at a weighted average price of $10.41 per share. This brings the cumulative total to date since the stock repurchase program began on March 5, 2020, to $153.8 million at a weighted average price of $8.41 per share.
Source: Q3-2021 Transcript
That is about 6% of the current market capitalization, a rather unusual vote of confidence for a REIT. If the NAV is accurate at around $15.00 per share and is moving up with time and inflation, ESRT's buybacks are easily the best use for its cash.
Verdict
It does come down a lot to what you think the Empire State Building is worth and what level of work from home you see in the new normal. All REITs carry leverage and a small difference in your asset value NOI can produce huge differences in the final NAV left for equity owners. We think there is a bullish case here, albeit a modest one. The valuation is favorable and the very high levels of inflation underpin asset values. The retained cash flow adds to our base valuation and there is modest embedded growth in the portfolio.
Source: Q3-2021 Earnings Presentation
We are giving this a buy rating with a price target of $10.80 (12X 2023 FFO) in 1 year.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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Comments (42)
Any selloff will probably add a little, it is a small position at this time. Usually I am early in things so I have to reinforce my decisions- and remember not to be too attached! BeaFayWray
I'm a lifelong NYer. The tourist related aspects to Empire St. Building are huge moneymakers but I don't understand why people would want their offices in the building.You are forced to wait for elevators that packed. The retail services in and around ESB are overpriced. Who wants to fight tourist crowds in a destination location when going to work everyday? Another issue is being on a 50 or higher floor in the event of a terrorist attack or fire. My final issue is that the building is almost 100yo and that should mean increased capex both maintenance and improvement.
The rest of the portfolio is generic office space.
Chicago for Nashville
San Francisco for Austin
New York for Miami Notice any themes?