Empire State Realty: Better To Observe From The Sidelines

Summary

• Empire State Realty Trust owns the iconic Empire State Building and derives significant revenues from its Observatory operations.
• Though 2022 visitation levels are markedly improved from 2021, international tourism still lags.
• While operations are likely to improve further into the new year, there are more lucrative upside opportunities elsewhere in the office sector.

Yongyuan Dai/DigitalVision via Getty Images

Empire State Realty Trust (NYSE:ESRT) is an owner and manager of office, retail, and multifamily properties in Manhattan and the Greater New York Metropolitan area. It is also the owner of one of the world's top-ranked travel destinations, the Empire State Building.

Shares in the stock have been under pressure for quite some time, even prior to the COVID-19 pandemic.

Seeking Alpha - Basic Trading Data Of ESRT

Seeking Alpha's current quant system rates shares as a "strong sell", with poor grades on most metrics. Wall Street is similarly unimpressed with the stock, with most providing a "hold" rating, though current targets indicate 16% embedded upside.

In the face of market pessimism, ESRT has been deploying available cash on share repurchases. Cumulatively, they've now acquired about 11% of their total shares outstanding. In a sense, there does appear to be a disconnect between the share performance and their results of operations, which continues to exhibit improvement over prior periods.

Importantly, visitation at the Observatory at the Empire State Building, a key aspect of their total revenues, has steadily improved and is well above levels reported in 2021. While this does create an upside opportunity in shares, visitation levels have been held back by the lack of international travelers. Though activity could certainly pick up in 2023, it may be best to hold on further initiation until at least their Q4 earnings release.

Recent Performance

In the third quarter of fiscal 2022, ESRT signed 335K square feet ("SF") of space. This is the most signed during the year in terms of square footage, though from a pure volume standpoint, the number of total leases signed is lower than prior quarters.

On average, the signings carried a weighted average lease term ("WALT") of 7.9 years. This, too, is down from the prior two quarters. In Q2, for example, signings were completed at 10-YR WALTs, while Q1 commanded 8.7 years.

In addition, the number of months of free rent also ticked higher to 8.7 months. This is up from 8.2 months in Q2. It is, however, down from the 11.4 months provided at the end of 2021.

Total cash roll-ups in their office portfolio impressed at 5%, led by significant markups on new signings in their Manhattan office portfolio. New spreads in this segment came in at 23.6%. This was partially offset by declining spreads on renewals and a 5% decline in rents in their Metro portfolio. In addition, their retail segment also exhibited continued rent weakness, with an overall decline of 10.5%.

Q3FY22 Investor Supplement - Comparative Summary Of Portfolio Operating Performance

ESRT signed several notable leases during the quarter, one of which was the renewal of Franklin Templeton. Following the renewal, the company has now addressed all of their space that was set to expire in Q3 of 2024.

In 2023, however, 5.5% of their total square footage is set to expire. This represents 6.4% of annualized revenues. More specifically, the expirations are weighted more heavily towards their Metro portfolio, where 7.7% of total square footage or 11.9% of annualized rent is set to expire.

Management did note 280K SF of known vacates and 98K SF of undecideds, which seems quite high and presents elevated vacancy risks. Nevertheless, management expressed confidence in ultimately achieving positive absorption during the year.

In their Observatory operations, which accounts for nearly a fifth of total revenues, visitation during the quarter came in at 687K. And NOI amounted to +$24.5M. This is up significantly from visitation of 255K and NOI of +$6.4M in the same period last year.

From a historical perspective, the Observatory previously contributed to about a quarter of the company's NOI. But on a trailing 12-month basis, its contribution stands at 19%. Organic opportunities for improvement, therefore, exist, especially if there are improvements in international-based tourism levels.

Liquidity And Debt Profile

At present, ESRT has total liquidity of +$1.2B. This includes +$387M of cash on hand and +$850M of availability on their revolving credit facility. Stable operating cash flows also provide the company with a continuing liquidity source to meet both their short and long-term obligations.

Their sizeable liquidity position is paired with a lower leverage position than their peer group. Currently, net debt as a multiple of adjusted EBITDA stands at just 5.6x. This is significantly lower than the 9.3x average reported by their peer set, which includes Boston Properties (BXP), Paramount Group (PGRE), SL Green Realty (SLG), and Vornado (VNO).

In addition to an overall lower load, the company also benefits from a favorable debt ladder, which is heavily tilted towards later years. Combined with no floating rate debt exposure, ESRT faces limited risks relating to repayment and interest rate fluctuations.

The flexible balance sheet enables the company to readily capitalize on market opportunities. Most recently, the company acquired a multifamily asset in Manhattan for +$115M. This was not only funded by available cash on their balance sheet, but also by proceeds from the successful disposition of non-core assets.

Dividend Safety

ESRT's current quarterly dividend is still about one-third of the payout from the first half of 2020. At that level, investors would receive a yield of about 6% at current pricing. Instead, the current dividend yields just 2%.

Seeking Alpha - ESRT Dividend Payout History

Though the current payout may not appeal to income-focused investors, the Board has sufficient cushion to enact increases in later periods. In its current form, the payout ratio is less than 20% of core funds from operations ("FFO").

Holding back any potential increase, however, is their net operating loss ("NOL") carryover. Presently, this carryover amounts to +$73M. This is notable because the NOL enables a REIT to reduce the amount required to be distributed. Normally, a REIT would have to distribute 90% of their ordinary taxable income. But having a loss carryover enables the REIT to instead preserve cash for other uses.

In this case, the company has been utilizing the cash on increased share repurchases on the basis of improper market valuation of their shares. YTD through mid-December 2022, ESRT has repurchased +$4.4M of their common shares at a weighted price of $6.67/share. On a cumulative basis, they have now acquired 11% of their outstanding shares at a weighted price of $8.34/share.

Main Takeaway

ESRT made further strides in leasing during the quarter, with notable performance on new signings in their Manhattan market. In addition, they successfully addressed a larger upcoming expiration and have expressed confidence in achieving positive net absorption in 2023.

Physical occupancy still lags, though it was up 70bps in the overall portfolio and 110bps in Manhattan. For the full 2022 fiscal year, management is expecting same-store physical occupancy to land somewhere between 84% and 86%. This would be much improved from the 82.4% reported at the end of 2021.

On a leased basis, occupancy levels are up 250bps from the prior year, and there is currently 430bps of opportunity available in their signed but not yet commenced pipeline. In total, in combination with free rent burn-off, ESRT has +$57M in contracted incremental rent pending in the pipeline. This should figure favorably into positive future earnings growth.

ESRT will also benefit from the continuing recovery of NYC-based tourism. As a top-rated travel destination, the Observatory at the Empire State Building continues to experience improving visitation, though a full recovery is now expected to be delayed due to the slower-than-expected return of international travelers. This resulted in a markdown in guidance for full-year Observatory NOI. Nevertheless, core FFO was bumped up $0.03/share at the low end from previous expectations.

Consistent with a prior analysis, the stock could make for a viable buyout target due to its strong balance sheet in relation to peers and its current trading levels, which still remains in discounted territory despite its move higher in recent months. Robust repurchasing activity on existing shares also lends support to the market disconnect.

Despite the potential upside, it may be prudent to place a hold on further initiation. While operating performance has held up, visitation at the Observatory hasn't improved as much as expected. Though it's possible activity could pick up, especially considering further global reopening, it's worth preserving the capital for at least another quarter or two.

Disclosure: I/we have a beneficial long position in the shares of VNO, SLG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.