Empire State Realty Trust Has Many Risks Facing It

Editor's note: A previous version of this article misstated the company's debt burden. The Fool regrets the error.

Empire State Realty Trust Inc (NYSE: ESRT  ) captures the imagination of investors around the world -- who wouldn't want to own their own share of the Empire State Building? However, despite its attractions, the trust does not look to be a very good investment.

Why not? Well firstly, the trust as a whole breaks rule 101 of investing: diversification. 

Diversification
Indeed, the trust takes its name and more than 30% of its total rent income from a single building, which could end up being its downfall

 

Rentable Square Feet

Annualized Base Rent

Empire State Building

2,869,726

$99,172,165

Realty Trust Portfolio Total

8,394,755

$307,157,650

Empire State Percentage

34%

32%

With one third of the trust rent coming from the Empire State building, the trust is exposed to some serious risks. In particular, those risks generally associated with old buildings as maintenance is required with ever increasing regularity. Indeed, the building is currently in the midst of a $550 million refit to modernize the building.

Source: David Shankbone

Unfortunately, there is also the very real, yet remote, risk of terrorism and building collapse that could wipe out 30% of the trusts revenue and its flagship asset overnight. However, it is reassuring to know that the Empire State Building has already survived an altercation with a twin-engine B-25 bomber and the building's construction of steel, marble, and brick makes it stronger than most modern "flat-pack" skyscrapers. That said, the trust does have terrorism insurance on the Empire State Building, with an aggregate total insurance of $1.5 billion, although the actual financial impact the trust would suffer depends on numerous factors. 

Dependence upon significant tenants
Aside from the lack of diversification in the trust's portfolio of assets, the trust also has a lack of tenant diversification, as its listing prospectus states:

We depend on significant tenants in our office portfolio, including LF USA, Coty, Legg Mason, Warnaco, a subsidiary of PVH Corp., and Thomson Reuters, which together represented approximately 22.2% of our total portfolio's annualized base rent as of June 30, 2013.

Debt
All real estate investment trusts (REITs) have debt; it's part of the business model. Debt is usually required for the acquisition of property portfolios. In this case, Empire State is not unlike its competitors.

While the debt-to-assets can appear extremely high, investors need to remember that the appraised value of the assets is higher -- thus resulting in a more digestible debt-load.

Either way, the company was expecting to receive nearly $1 billion in cash from the public offering, but most of this is going to third parties -- only $270 million will be used to pay-down debt. The trust's listing prospectus also carries this worrying statement on the issue of debt:

Our outstanding indebtedness upon completion of this offering reduces cash available for distribution and may expose us to the risk of default under our debt obligations.

Elsewhere
Two companies that look to be better choices than Empire State Realty are Washington Real Estate Investment Trust  (NYSE: WRE  ) and CommonWealth REIT  (NYSE: EQC  ) .

Firstly, both companies have a lower level of debt as a percentage of assets than Empire State Realty. Secondly, they both offer greater diversification in their property portfolios. Thirdly, CommonWealth is trading at a discount to its net asset value per share, indicating that you can currently purchase $1 of the company's property portfolio for around $0.78.

Company

Net Asset Value Per Share

Debt to Assets

Washington Real Estate Investment Trust

$11.5

60%

CommonWealth REIT

$31

46%

Commonwealth has many properties spread throughout the U.S. and Australia, mitigating the risk of diversification Empire State itself faces. 

Meanwhile, Washington Real Estate has numerous properties across the office, retail, and residential markets, with multiple tenants, spreading the risk and decreasing the potential effect of the loss of a single tenant. That said, the company does trade at a premium to its net asset value per share. Still, the trust's total return of 39,000% in the period between December 31, 1971 and December 31, 2012 more than justifies this premium. 

On the other hand, during the past five years, the trusts income has nearly halved, and shareholder equity has only expanded 3%, but REITs are not known for their explosive earnings growth. 

Foolish summary
So to sum up, it seems there are many risks currently facing Empire State Realty, and there could be better opportunities out there. All in all, with so many risks facing Empire State Realty, is the glory of holding a share of the Empire State Building worth it?

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