Few would argue with New York City's status as one of the most incredible cities in the world. Landlord Empire State Realty Trust (ESRT 2.39%) is a quick way for investors to get exposure to the Big Apple, including a piece of one of the most iconic properties on Earth. But don't jump in before you read this, because there's more to consider here.
Real estate investment trust (REIT) Empire State Realty Trust is the owner of the Empire State Building. That's one very impressive trophy property, to say the least. It also says a lot about this REIT. For starters, the Empire State Building is an office tower, which highlights the REIT's focus. However, office buildings in New York City, including the Empire State Building, often have retail at street level. And thus Empire State Realty's rent breakdown is 93% office and 7% retail.
The REIT generates some of its rents outside New York City, so all in all, the rental breakdown is 75% New York City office, 18% from office properties near the city, and 7% from retail. There's a little bit of diversification in there, but not a lot. New York City office is the driving force, with the performance of the retail properties highly reliant on the success of the office space above them, since that's what drives foot traffic. Empire State Realty Trust is a big bet on the Big Apple office market.
At first glance, this focus hasn't worked out very well of late, given the shift toward working from home in the face of the coronavirus pandemic. Revenue fell roughly 15% through the first nine months of 2020. But there's another wrinkle here: The revenue decline was largely the result of a steep drop in visitors to the Empire State Building's observation tower, an attraction tied to the city's tourism traffic. Rental revenue alone only fell about 2%, which isn't that terrible. In fact, by September, occupancy was 89.4%. With new leases added to the mix, that figure would rise to 91.7%.
So when you step back, Empire State Realty Trust is a New York City-focused office REIT with some strange wrinkles, including a little office exposure outside the city, some street-level retail, and the unique observation tower tourist attraction. But that's not where the nuances end.
And focused some more
The Empire State Building made up roughly a third of the REIT's rent roll prior to the pandemic. Another five buildings accounted for roughly 40% of rents. So nearly 75% of the company's rent roll is tied to just six buildings in New York City and surrounding locales. That's concentration risk on top of concentration risk. This is not an appropriate REIT for a long-term investor looking for diversified businesses to own.
And then there's the issue of the office market to think about. Office leases tend to be longer in nature -- think five to 10 years or so. And Empire State Realty, in an effort to keep its properties filled, has been granting rent concessions. In the third quarter, new leases were, on average, 5% lower than previous leases. So there's going to be some lingering pain. To be fair, new leases in New York City were made at higher rates, which helps to offset the overall hit from concessions -- but that wasn't enough to offset the full hit to the portfolio.
All in all, then, Empire State Realty Trust is a New York City office-focused REIT with some concentration issues, nuances around the edges (retail and the observation tower), and a growing headwind in its rent base (thanks to the leasing issue). In the long run, it probably muddles through this period, but once you dig in to the finer details, it looks like a story for more aggressive investors.
Empire State Realty Trust eliminated its dividend last June, which isn't shocking given the pandemic. Dividend investors will probably want to avoid it until the dividend is back, and perhaps even a little longer. That means only more aggressive investors -- perhaps ones focused on turnaround stories -- will find this REIT appealing right now. Given its focus and some unique nuances, it's an acquired taste. Just go in knowing that, because of the leasing picture, the recovery may be a bit slower than you hope.