Empire State Realty: Adverse Circumstances For Office & Retail Focussed REIT (NYSE:ESRT)

Office and retail focused real estate investment trusts (“REITs”) have been affected the most during the Covid-19 pandemic. Work from anywhere (WFA) instead of work from office (WFO) reduced the demand for office space. On the other hand, restriction in opening retail businesses during the pandemic has also impacted the demand for retail spaces. Kastle Systems in its weekly work barometer reported that, as of the end of April 2022, average physical building occupancy of office buildings in the U.S. remains around 40%-45% of pre-pandemic levels.

Empire State Realty Trust, Inc. (NYSE:ESRT) operates as a pure-play Greater New York and Manhattan-focused REIT that owns the landmark Empire State Building office and observation deck. This REIT is among the holders of the largest commercial property space (office and retail) in New York and Manhattan. Despite the pandemic easing out, the ongoing high inflation, unemployment and looming recession continue having negative impact on ESRT’s portfolio of properties.

WFA model possess a significant threat to the Office REITs

The WFA culture is having a tremendous impact on the rentals of office-based REITs. Since the beginning of Covid-19 pandemic, employees have been able to adapt with technology-enabled solutions in order to collaborate and maintain productivity even as they work from remote locations. After getting accustomed to working mostly from their home, employers are struggling to get employees back to the office. Companies that have a high number of older construction are additionally getting impacted by the higher cost of maintenance and operation, while at the same time the rents are going down.

Property-technology services firm Kastle, which tracks key card entry to the office buildings, reported an alarmingly low level of attendance in the office. During mid-April, it recorded that, on average, 42.8 percent of workers attended their offices across 10 metropolitan areas, whereas prior to the pandemic, that was almost 100 percent. It is obvious that the WFA model is offering notable benefits to the companies and their employees.

Organizations can reduce real estate costs as the space requirement decreases. WFA programs also hugely expand an organization’s potential talent pool to include workers tied to a location far from that of the company. So, companies can hire talent globally while mitigating immigration issues. WFA can reduce attrition, as the employees start enjoying the comfort from working at their home, and thus become less interested to move out from their current location. As has been witnessed, a significant number of employees worked harder and longer because they were working in their comfort zones.

This ultimately increases productivity. Workers get locational flexibility, eliminate traveling, and report better work/life balance. However, there remains a certain downfall, too, which may lead the employers to rethink their strategies and go back to their earlier mode of operation. WFA negatively impacts communication, including “mentoring, knowledge sharing, brainstorming and problem-solving; data security and regulation, camaraderie, socialization, performance evaluation and compensation.”

A positive news for office REITs is that, of late, the companies are asking their employees to return to the office. Even if the offices don’t operate at 100 percent attendance, hybrid remote work solutions will gain increasing acceptance over the work from home only practices. Offices will continue to be the key element in facilitating collaboration, harnessing innovation, and maintaining the company culture.

Portfolio of Empire State Realty

Empire State Realty Trust owns and operates around 10 million square feet of office space, in 14 office properties, including nine in Manhattan, three in Fairfield County, Connecticut, and two in Westchester County, New York. ESRT also owns approximately 700,000 rentable square feet in the retail portfolio.

Empire State Realty earns more than 40% of its revenue from the Empire State Building office and observation deck. The tower’s observation deck, named Edge, is a giant terrace situated at a height of 335 meters. The observation deck and museum, which reopened to visitors on July 20, 2020, has been disappointing in terms of footfall and earnings. New observation decks at Hudson Yards and One Vanderbilt in Manhattan pose a tough competition.

According to Konrad Putzier, a journalist from Wall Street Journal, “The iconic tower looks vulnerable to losing office tenants as more companies embrace remote work or cheaper satellite offices outside city centers. Some in the industry say it is worse-off than many peers because the building relies on smaller office tenants, which tend to be more at risk during a downturn.”

The age of this 90-year-old building is another concern. Old buildings suffer from higher maintenance cost on one hand and stiffer competition in terms of rental rates on the other hand. During office-market downturns, new buildings lower their rent. Empire State Realty has been addressing some of these issues. Over the past decade, ESRT spent heavily on renovating, installing modern and fast elevators, and making it more energy-efficient.

The good news is that there are a number of corporate tenants, including LinkedIn and Shutterstock. In addition, smaller divisions of larger companies, also have rented space in this building. Many of the larger tenants have entered into long-term lease agreements. Shutterstock signed an 11-year lease in 2013 for its headquarters in the building. As a result of this, the company is assured of rental revenue to some extent.

Investment thesis

Technology-efficient remote and hybrid working conditions have improved significantly over the past few years, and are expected to improve with time. Nowadays, office building owners are not only competing with other office building operators but also are fighting it out with the technology-enabled communication and collaboration tools. The future of office REITs will largely be determined by how these technologies complement and/or substitute the requirements of physical office space.

This dynamic presents a significant source of uncertainty for office real estate owners. The retail REITs also suffer from lower levels of occupancy and reduced rentals during an economic downturn. Investors of Empire State Realty Trust have to mainly rely upon the rental revenue of its office and retail spaces and primarily depend on the rentals of Empire State Building office and observation deck. A prolonged economic slump would increase the risk of default of rent or non-renewals of lease agreements.

The yield offered by this REIT is quite low but sufficiently covered by its funds from operations (FFO). As the price is quite low (around $7) at present, there is hardly any chance for a steep fall of ESRT. However, I don’t find a strong enough reason for investors to accumulate these shares, as the future outlook doesn’t seem to be very positive. The risk associated with Empire State Realty Trust is high enough to ignore the steady ~2 percent dividend yield it generates.