South wind

Empire State Realty Trust, Inc. (NYSE: ESRT) owns the iconic Empire State Building in New York (“NYC”) and a publicly traded real estate investment trust (“REIT”) that owns a portfolio of other office, retail and multifamily in Manhattan and the greater New York metropolitan area.

Compared to their New York counterparts, SL Green Realty Corp (SLG) and Vornado Realty Trust (VNO), they are significantly less diversified in the number of income-generating assets and are smaller in size, with a value of business less than +$5.0 billion. Trading volume is also slightly lower with a high degree of short interest at 9%. This, however, is comparable to the shorted quantity identified with both SLG and VNO.

In Search of Alpha - ESRT Trading Overview

In Search of Alpha – ESRT Trading Overview

Over the past five years, the stock has performed poorly, down nearly 70% in that time. Worse still, stocks trended lower even before the COVID-19 pandemic began. Investors holding since 2013, for example, would have achieved a compound annual growth rate (“CAGR”) of less than 1% through 2019 and would be sitting on a negative CAGR of 7% if they were still holding today.

Although stocks partially recovered from pandemic lows, they never fully returned to pre-pandemic trading levels. On a YTD basis, ESRT is outperforming SLG and VNO, down just over 22%, but that still brings little comfort to long-time investors who are suffering deep 5-year losses.

YCharts - ESRT YTD Total Returns vs Competitors

YCharts – ESRT YTD Total Returns vs Competitors

Right now, stocks are trading at fresh 52-week lows and 8x funds from futures (“FFO”). This compares to 13.5x at the upper end of their 52-week range, representing a gap of just under $5 from their highs and lows.

For many investors, the stock may seem like dead money. And it wouldn’t be without merit given their past performance. But for a dead cat, it bounces high. Since its 2020 lows, for example, it has gained more than 100% on optimism surrounding trade reopening.

Similarly, ESRT is expected to see a 15-20% return following a broader reversal in market sentiment. A healthy balance sheet, strong attendance trends at the Empire State Building and significant upside potential for the quarterly dividend are a few fundamental catalysts that could support a recovery from current levels. For potential investors, ESRT is a beaten-down opportunity that merits further consideration.

A wallet worn by the irreplaceable Empire State Building

ESRT has a limited portfolio of office properties, with the asset class accounting for between three quarters and 80% of their total net operating income (“NOI”). In addition to Empire State Building rental revenue, ESRT also derives revenue from the building’s observatory operations, which until Q2FY22 accounted for just under 10% of the total trailing twelve-month NOI (“TTM “). But as attendance continues to improve, fees are expected to reach 20% of the NOI by the end of the year.

July 2022 Investor Presentation - NOI Breakdown by Asset Class

July 2022 Investor Presentation – NOI Breakdown by Asset Class

As of the date of publication of their results, attendance at the Empire State Building has already exceeded one million visitors, or 60% of 2019 levels. From the perspective of NOI recovery, however, the rate was 80 %, supported by higher pricing power.

Despite price hikes, tourists are still drawn to what is often dubbed the world’s most famous office building. In fact, TripAdvisor’s 2022 Travelers’ Choice Award ranked the building as the No. 1 attraction in the United States and No. 3 in the world. With plenty of upside remaining on visitation numbers, ESRT should see continued earnings growth in the periods ahead.

The rapidly deteriorating economic conditions can be seen as a headwind. But this turbulence is felt above all in the equity, currency and real estate markets. Consumers, meanwhile, remain in a stronger financial position than they were during previous market downturns. This is marked by a high, albeit moderate, savings rate and lower delinquencies. Additionally, there continues to be a shift from a goods-based economy to a more service-based economy. This should serve as a continuous tailwind for the ESRT.

Long-term rental commitments at favorable rental spreads

Aside from the tourist aspect, the Empire State Building also serves as Manhattan’s premier office building, with LinkedIn as its primary tenant on a 14-year lease, expiring in 2036. Overall, at the end of the second quarter, the building was approximately 84% leased and 80% physically occupied. Although this rate is down significantly from the 95% rate at the end of 2019, it presents an attractive opportunity for organic growth in the periods to come.

Q2FY22 Investor Supplement - List of Top 5 Tenants

Q2FY22 Investor Supplement – List of Top 5 Tenants

Despite weakened occupancy figures, leasing activity remains strong, with over 320,000 square feet (“SF”) signed in the current period. This is a significant increase from the 190,000 signed at the same time last year. Additionally, net effective rents increased 25% year-over-year in their Manhattan office portfolio and 16% sequentially.

Supplement for Investors T2FY22 - Portfolio Exploitation Indicators

Supplement for Investors T2FY22 – Portfolio Exploitation Indicators

The weighted average lease term also increased to ten years, from 8.7 years last quarter and 8.3 years in Q2FY21. This gives an indication of their tenants’ confidence in the sustainability of the office model, even if current trends favor more hybrid working arrangements.

The 350 basis points (“basis points”) difference between rental and physical occupancy provides additional visibility on future RNE growth. Combined with free rent consumption and a strong pipeline of rental activity in Q3, ESRT is expected to realize approximately +$53 million in incremental contract rent.

A flexible balance sheet with a significant advantage in paying dividends

ESRT’s operations are backed by a balance sheet that offers greater flexibility than their peer set, which includes SLG and VNO. Net debt, for example, stands at just 5.8x adjusted EBITDA versus an average of 9.2x reported by their peers. Minimal exposure to floating rate debt is also another competitive advantage, particularly in an environment marked by rising interest rates.

July 2022 Investor Presentation - Comparing ESRT's Leverage Position vs. Peer Set

July 2022 Investor Presentation – Comparing ESRT’s Leverage Position vs. Peer Set

The limited maturities of short-term debt also negate any short-term repayment risk. The existing liquidity of over +$1.0 billion, which includes +$360 million in cash, also ensures that the company has sufficient funds to meet its major recurring obligations, which include interest and their dividend payments.

July 2022 Investor Presentation - Debt Maturity

July 2022 Investor Presentation – Debt Maturity

At 5.1x, interest is sufficiently covered by earnings. And with a base payout ratio of just 23%, the current dividend is also well covered. At these hedging levels, the ESRT has room to embrace an increase from current levels, which sit at just $0.035/share on a quarterly basis, down substantially from pre-pandemic days. At its old rate, the payout would yield over 6% at the current price, significantly better than the meager 2% currently offered.

ESRT’s share price performance should correlate with visit numbers

The Empire State Building is one of the most famous buildings in the world and a major tourist attraction in the United States and abroad. As the primary revenue-generating asset in the ESRT portfolio, high attendance numbers should correlate with stock performance. Instead, the two have diverged significantly, with hits at 60% of 2019 levels but the stock at fresh 52-week lows and not too far off their 2020 lows.

Lack of portfolio diversification is a risk that could expose ESRT to significant losses, particularly if visitation trends mark a sharp reversal due to the rapidly deteriorating economic outlook. But there are few indications that the slowdown is leading to a drop in travel demand.

While rising rates have caused turbulence in global housing, currency and equity markets, consumers continue to have a higher degree of savings that partly funds experiences that were missed in 2020. This includes trips to the Empire State Building, which has been rated the top tourist attraction in the United States by TripAdvisor.

There is also significant upside potential in ESRT’s quarterly dividend payout, which is pegged at just $0.035/share, significantly below the pre-pandemic benchmark. If the payout were to return to these levels, it would return over 6% at current price levels. This would incentivize income investors to hold the equity instead of putting their money in a savings account which, at current rates, earns more than the rate earned on the company’s current dividend payment.

Plenty of organic opportunities embedded in the stock support a recovery from current trading levels. A flexible balance sheet and an irreplaceable asset in the Empire State Building at moderate valuations also make the stock a viable buyout target, especially given growing frustrations over the stock’s performance from institutional investors and other long-time investors.

All things considered, a 20% upside from current trading levels is not out of the question. This would take the stock to around $8 and represent a price multiple of just under 10 times the forward FFO. For potential investors, these returns should be sufficiently higher than current risk premia.