Difficult Manhattan Office Market Will Continue to Weigh on Empire State Realty in 2024

Equity Analyst

Suryansh Sharma

Empire State owns and manages about 9.4 million square feet of commercial real estate portfolio composed principally of office buildings in Manhattan and the greater New York area. Its office portfolio fetches lower rents and has higher vacancy rates, reflective of an older, less premium building stock. Management has successfully focused on redeveloping its older office properties in recent years by providing more amenities and aligning its portfolio to meet the maintainability requirements of its clients.

The company also owns the famous Empire State Building and operates the iconic Empire State Observatory deck. The observatory business has historically demonstrated great pricing power and resiliency throughout the economic cycle and contributed around 25% of companywide NOI before the pandemic. Flailing international tourist demand due to pandemic restrictions and competition from newer observation decks battered the business in 2020 and 2021. However, visitor counts are recovering and are expected to reach around 80% of the prepandemic level by 2025.

The economic uncertainty emanating from the pandemic recovery and the remote work dynamic have created a challenging environment for office owners. Employees are still hesitant to return to the office as office utilization remains around 50% of the prepandemic level. The vacancy rate for office spaces in Manhattan was 22.8% in fourth-quarter 2023, roughly 1,100 basis points higher than prepandemic levels. On the supply side, approximately 5 million square feet of office space, which amounts to around 1.25% of the total inventory, is currently under construction in Manhattan. We expect this additional supply to further pressure fundamentals in the market. The Manhattan net absorption rate remained negative as of fourth-quarter 2023 and rental growth figures are disappointing, especially given the highly inflationary environment.

In the long run, we believe that hybrid work solutions will gain increasing acceptance, but offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining the company culture.

Business Strategy & Outlook

We assign a no-moat rating to Empire State Realty Trust. Given the availability of substitutes within the realm of Class A office space, limited supply restrictions in the company’s key geographic markets, the uncertainty in demand associated with the remote work dynamic, and the ease with which competitors can lure tenants away with concessions, we view a large proportion of properties as replicable and, therefore, do not believe that the company has a maintainable competitive advantage. 

Effects of Remote Work

Empire State’s portfolio contains high-quality assets that are strategically located in metropolitan areas with good growth potential and somewhat supply constraint characteristics. However, the remote work dynamic is putting significant pressure on the owners of office real estate. The pandemic has massively accelerated the remote work trend, and it has shown us that technology-enabled solutions can help employees collaborate and maintain productivity even as they work remotely. A significant proportion of the US office-going workforce has now worked remotely for over two years and employers are struggling to get them back to the office. As per Kastle Systems' weekly work barometer, the average physical building occupancy of office buildings in the US remained around 50% of prepandemic levels at the end of 2023. We expect physical building occupancy rates to improve with time, but we do not see them reaching prepandemic levels any time soon. Technology-enabled hybrid and remote work solutions have improved materially over the past few years, and we can expect them to keep improving with time. Office owners are now not only competing with other office owners, but they are also competing with technology-enabled communication and collaboration tools that have called into question the future of the industry. This dynamic presents a significant source of uncertainty for office real estate owners. 

The dire predictions about the death of office space in the early days of the pandemic have not really materialized. Multiple surveys have shown that employers want their employees to come back to the office. We are already starting to see companies sign leases with long durations, demonstrating confidence in the long-term future of the office. In the long run, we believe that offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining the company culture. 

Having said this, hybrid workplace policies are now increasingly becoming the norm in corporate America and present a very significant challenge to future office demand. As companies adopt hybrid work policies, workplace management solutions like hot-desking can materially reduce the square footage per employee leading to further stress on office demand. We can already see some evidence of this dynamic playing out as companies are starting to track the utilization rate of various spaces in their portfolios and then using tech solutions to optimize the utilization. These solutions can have a structural long-term impact on the demand for office space. For instance, if a certain company predicts that on average its employees will return to the office two days per week, then it can shrink its existing office footprint to maximize space utilization. It can also use the services of flexible office space providers to plan for days when a high percentage of employees come to the office. 

The impact of the hybrid work-related disruption can be seen in office real estate fundamentals like vacancy rates, net absorption, and rental rates. The national vacancy rate for office spaces was 19.7% for the fourth quarter of 2023, up approximately 8 percentage points compared with prepandemic levels. The vacancy rates for office buildings in Manhattan are even worse. Cushman & Wakefield reported a vacancy rate of 22.8% for office buildings in Manhattan. To put this number in context, the prepandemic average office vacancy rate in Manhattan was approximately 10%. The Manhattan net absorption rate remained negative as of the fourth quarter of 2023 and rental growth figures are disappointing, especially given the highly inflationary environment.

Efficient Scale

Efficient scale is the primary moat source for real estate investment trusts. This moat source refers to situations where companies are effectively serving a very limited market size, and potential competitors have little incentive to enter the market because by doing so, they would lower the industry’s returns to below the cost of capital. We do not see any evidence of these competitive dynamics in Manhattan for office properties. 

First, we think that the market size for office buildings in a particular submarket is poorly defined. The built-up nature of central business districts across the country allows for a significant concentration of fungible office square footage within a limited area. However, the definition of an office market can in some senses be extended to an entire metropolitan area, as evidenced by the prevalence of corporate relocations within a given region. In other words, the demand for office space within a particular submarket is not fixed as potential office space occupiers can easily move to other submarkets within a region. 

Second, the owners of office buildings do not have pricing power because the office markets are highly fragmented, with no single entity owning a significant share of inventory within a given geography. We estimate that Empire Realty owns approximately 2% of the total office inventory in the Manhattan market. This limited market share prevents the company from achieving the pricing power necessary to achieve an efficient scale moat source. 

Last, when assessing an efficient scale moat source, we typically look for a material cost to enter a market and the necessity of a significant market share to make these fixed costs worthwhile. Although large office properties can be costly to develop and acquire, no additional barriers are preventing new players from entering a market. Each property can operate on a stand-alone basis, and the benefits of accumulating properties in a single location are limited. This allows markets to remain fragmented and encourages new entrants when excess returns are to be had. 

We believe that the primary potential moat source for Empire State’s retail portfolio is also efficient scale. Empire States' retail portfolio contains high-quality assets in the Manhattan area that see a significant volume of foot traffic and are strategically located in some of the best submarkets with high population density and high household incomes. Historically, locations like these are highly sought after by any retailer. However, the continued growth of e-commerce has placed significant pressure on traditional brick-and-mortar retail. Consumers were forced to do much of their shopping online during the coronavirus crisis, and we believe that many of the changes to shopping habits have been permanent. While the concentration of topnotch tenants across Empire State’s portfolio can provide an experience for consumers that is hard for other retailers to replicate, there is some uncertainty about the future of sales growth in traditional retail space due to e-commerce. Given this dynamic, we believe that the retail portfolio of the company does have a moat. 

Observatory Deck Business

In addition to a portfolio of mostly Manhattan office properties, Empire State Realty operates an observation deck atop the iconic Empire State Building. While the observation deck boasts ostensibly impressive prepandemic net operating income margins of around 75%, this number is inflated because the company owns the building and does not have to pay rent on it. When market rent is factored in, the NOI margin decreases to 14%. Nevertheless, we think this segment does have some elements of brand-based intangible assets. The Empire State building is recognized by tourists worldwide who are willing to pay a high price to experience the view and the history that is associated with the building. Additionally, the observation deck is priced at a level that is slightly higher than that of rival decks like Top of the Rock and One World Observatory.

However, we do not think that the brand-based intangible asset argument for the observatory deck segment merits the award of a moat for the entire company, for a few reasons. First, the percentage of companywide net operating income derived from the observatory is relatively small. Therefore, the observatory segment has a modest impact on overall returns on invested capital, and we think that the company will not be able to outearn its cost of capital over the next 10 years. Second, the number of visitors to the observatory plummeted in 2020 and 2021 because of travel restrictions due to the pandemic. This shows that the observatory business is vulnerable to significant uncertainties. Finally, the Empire State observatory deck is not unique; there are at least five other comparable observatories in New York City competing for visitors. The number of yearly visitors to the Empire State building had been falling constantly even before the pandemic, reflecting higher competition from newer observatories. 

Switching Costs

We estimate that Empire State has an average lease term of around 8-9 years. We do not think the mere length of these contracts constitutes a switching cost for the firm, given that our time horizon for a narrow moat is 10 years. Contract terms are negotiated by companies that will assess their business needs over the time horizon of the lease. The preponderance of comparable substitutes prevents the company from dictating favorable lease terms. Furthermore, leases are not fully binding and can be terminated by tenants, with termination income not constituting enough of a financial sum to constitute switching costs.

Competitive Dynamics and Pricing Power

We point to the broker-driven nature of the commercial real estate market as further evidence that Empire State lacks pricing power. Brokers such as Jones Lang LaSalle and CBRE negotiate on behalf of tenants to ensure that the terms of lease agreements are priced appropriately. Because of the third-party broker arrangement, there is little opportunity for the company to directly influence a leasing decision, and leasing terms tend to be specified to meet client needs and are reflective of current market rates coordinated through the brokers. This dynamic is reflected in Empire State’s inability to charge a premium on its properties on a rent per square foot basis as compared with properties of similar quality and location. This points to the commodified nature of office space, supporting our assertion that Empire State lacks a moat. 

Empire State invests primarily in central business districts in New York City, the nation’s largest metropolitan area, with over one fourth of the business district office space in the country. As compared with suburban markets, these urban markets are considerably more land constrained and are subject to more stringent zoning restrictions limiting construction. In most metropolitan areas these restrictions are informal, with proposals for development being subject to a bureaucratic and opaque approval process. However, in San Francisco, office development is subject to explicit annual limits on new construction, which in part explains why supply has been constrained. Although we think these limits make CBDs a more attractive location to own office space, we do not view the restrictions as sufficient to constitute a regulation-driven intangible assets moat source.

Empire State has strategically concentrated on central business district properties in New York City in a bid to benefit from the city’s somewhat supply constrained nature and its pre-eminence as a global talent hub. Indeed, the New York City market faces significant geographic constraints, with the island of Manhattan particularly immune to the sprawl that characterizes other large metropolitan areas, such as Houston. In addition, a relatively stringent zoning code adds to the supply constrained characteristic of the market. Nevertheless, we posit that New York is in fact not the most supply constrained metropolitan area in the United States, with markets such as San Francisco exceeding it in that regard. Furthermore, recent history shows that supply additions are not hard to come by despite the scarcity of vacant land in the metropolitan area. 

In fact, we would point to the Hudson Yards megadevelopment, which is added about 10 million square feet of mostly Class A office space, as a prime example. Additionally, the recent emergence of submarkets such as downtown Brooklyn and the Chelsea Market demonstrates that adjacent neighborhoods always represent a potential source of new supply in a particular region. Although zoning constraints often pose a challenge, the rezoning of Hudson Yards and Midtown East are salient examples demonstrating that such changes are infrequent but not impossible. Therefore, we think Empire State’s focus on New York City's central business district properties is prudent but does not merit a moat rating. Over the long run, office markets tend to see supply additions commensurate with additional demand. We think that the company and its competitors have benefited modestly from supply constraining regulations but do not view this as an enduring and strong enough dynamic to support the generation of excess returns over the next 10 years.

Additional supply is added to the market via new developments but also redeveloping older buildings to meet the latest needs of the market. Many developers focus on redeveloping Class B and C properties to Class A properties to sidestep limits on new construction. The investments into redevelopment are often accompanied by strong returns. Firms can pump $100-$200 per square foot into building renovations and achieve rent increases of $10 to $20 annually. We see this as a substantial source of new supply for high-quality inventory as the company’s core markets are littered with eligible redevelopment opportunities. For example, Class B property in New York provides plenty of candidates for redevelopment, with Class B asking rents often in the neighborhood of $55-$65 per square feet, much lower than their Class A counterparts that command upward of $80 per square feet. 

Conclusion

We use an adjusted ROIC calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Empire State has averaged an adjusted ROIC of approximately 900 basis points below our 7.0% weighted average cost of capital. We expect the adjusted ROIC of the company to remain materially below the WACC over the next decade. Therefore, we believe there is currently not enough quantitative or qualitative evidence to support a moat for Empire State Realty.

None

Economic Moat

Empire State Realty Trust

Empire State Realty Trust, Inc. is a real estate investment trust, which engages in owning, managing, acquiring, and repositioning office and retail properties. It operates through the Real Estate and Observatory segments. The Real Estate segment includes ownership, management, operation, acquisition, repositioning, and disposition of real estate assets. The Observatory segment manages observatories at the Empire state building. The company was founded on July 29, 2011 and is headquartered in New York, NY.

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