Business context and reporting period
Empire State Realty Trust, Inc. filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2016. The REIT owns and operates office and retail properties in Manhattan and the greater New York metropolitan area, as well as the Empire State Building observatory. Its portfolio comprised 10.1 million rentable square feet. ESRT owned approximately 46.0% of its operating partnership units; the partnership held substantially all assets and conducted substantially all business.
Financial and operating highlights
Amounts below are in millions, except per-share data, percentages, and where noted.
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Total revenue | $165.8 | $164.8 | $322.9 | $316.7 |
| Operating income | $44.2 | $45.0 | $78.3 | $68.8 |
| Net income | $24.6 | $26.6 | $41.3 | $34.5 |
| Net income attributable to common stockholders | $11.1 | $11.1 | $18.5 | $14.3 |
| Diluted EPS | $0.09 | $0.10 | $0.15 | $0.13 |
| Operating margin | 26.6% | 27.3% | 24.2% | 21.7% |
Q2 revenue increased 0.6%; operating income declined 1.9%. For the first half, revenue rose 2.0%, operating income rose 13.8%, and common-stockholder net income rose 29.9%. Q2 observatory revenue increased 4.0% to $31.8 million; first-half observatory revenue rose 8.6% to $53.0 million. Rental revenue was nearly flat in Q2 but increased 2.1% for the half.
First-half operating cash flow was $92.1 million, versus $77.1 million a year earlier. Investing used $74.0 million, including $78.7 million of building improvements; financing used $29.3 million. Cash and cash equivalents were $35.5 million at June 30, down from $46.7 million at year-end. First-half capital expenditures were $36.5 million, excluding tenant improvements and leasing commissions.
Total debt principal was approximately $1.664 billion; carrying value was $1.659 billion. Management reported a 4.08% weighted-average interest rate, 5.1-year weighted-average maturity, and debt equal to approximately 24% of total market capitalization. Approximately $336 million of debt maturities fell in 2017, excluding amortization. The company had $760 million available on its $800 million revolving facility at June 30; on July 6, 2016, it increased committed capacity to $1.1 billion. It reported compliance with applicable debt covenants. The quarterly dividend was $0.105 per share, up 24% from previous quarters.
At June 30, the total portfolio was 86.6% occupied and 89.4% leased including signed leases not yet commenced. The Manhattan office portfolio was 84.9% occupied and 88.4% leased; the Empire State Building was 88.7% occupied and 90.7% leased. ESRT signed 45 leases totaling 176,533 square feet in Q2, with a 39.4% mark-to-market rent increase overall; new Manhattan office leases achieved a 58.1% increase.
Material changes versus prior periods
- First-half operating income improved as revenue increased and operating expenses declined 1.3%. Lower property operating and observatory expenses and reduced depreciation helped; higher general and administrative expenses and interest expense partly offset the improvement.
- General and administrative expense rose 30.8% in the first half, including higher litigation costs, incentive compensation and equity compensation. Q2 expense also included $1.5 million of incremental formation-litigation costs.
- Interest expense rose 5.2% for the first half, reflecting higher debt balances and the cost of the 2015 senior notes. ESRT refinanced a $20.2 million mortgage in March 2016 with a $50 million, ten-year fixed-rate loan at 3.7%; it recorded a $0.4 million prepayment penalty and $0.2 million write-off of financing costs.
- First-half 2016 included a $30.2 million unrealized loss on interest-rate swaps in other comprehensive income; there was no comparable loss in 2015. The swaps’ net liability was $32.2 million at June 30.
- The construction-management business ceased soliciting new work in 2015 and completed its remaining projects; related construction revenue and expense were absent in 2016.
Outlook, management commentary, risks and contingencies
The filing provides no specific earnings or revenue guidance. Management expected positive operating cash flow and planned to meet short-term needs through operations, debt issuance and available revolver capacity. Longer-term needs, including acquisitions, redevelopment and capital spending, could be funded with operating cash flow, debt, equity or asset sales. ESRT expected approximately $52.8 million of tenant improvements and leasing commissions under existing leases over the 12 months after June 30, principally tenant improvements. Management described its Manhattan redevelopment and repositioning program as nearing completion and said it expects the program to support higher occupancy and rents over time, while noting that repositioning can temporarily reduce occupancy.
Management identified tourism, weather, ticket mix and competition as factors affecting observatory operations. Broadcasting is also exposed to industry changes and competition. CBS, NBC and WNET notified ESRT they would leave at the ends of their lease terms in 2017 or 2018; their leases generated about $6.3 million of 2015 revenue, including reimbursements. Renewed Univision and Emmis agreements carry lower initial annual revenue than prior levels.
Formation-transaction litigation and related arbitration remained a contingency. The Second Class Actions had been dismissed, with leave to appeal denied in June 2016; an arbitration brought by 12 investors who opted out of an earlier class settlement had begun, with hearings scheduled to resume in October 2016. ESRT stated it could not reasonably estimate the timing, outcome, or potential loss, and disclosed indemnification obligations that could expose it to costs. The filing also identifies lease rollover, vacancy and leasing costs, interest-rate changes, debt refinancing, development costs, tenant defaults, tourism trends, environmental matters and REIT qualification as risks. A 1% increase in short-term rates was estimated to increase interest expense by approximately $3.0 million based on variable-rate debt balances.
ESRT estimated $52.8 million of remaining lease-related capital costs and separately disclosed $59.5 million of building improvements included in accounts payable and accrued expenses. Certain properties contain asbestos-containing materials, but management reported no current plans that would trigger removal requirements and could not reasonably estimate the related conditional retirement obligation. Management said identified environmental remediation was completed and expected remaining matters not to have a material impact, while cautioning that all liabilities may not have been identified. Disclosure controls were considered effective, and no material change in internal control was reported.
Important facts for investors to verify
- Confirm the timing and funding of approximately $336 million of 2017 debt maturities, and assess the impact of the revolving-facility expansion after quarter-end.
- Track occupancy, lease commencements, rent mark-to-market results, and the costs and timing of the remaining $52.8 million lease-related commitments.
- Monitor departures of CBS, NBC and WNET, replacement demand and capital spending for broadcasting space, alongside observatory visitor and revenue trends.
- Review subsequent developments in the investor arbitration, possible indemnification costs, and the effect of formation-litigation expenses.
- Assess the effect of interest rates and swap valuations: the $32.2 million swap liability reduced equity through unrealized losses, although management stated the loss had no effect on cash flows.
- Compare dividends and non-GAAP measures such as FFO with operating cash flow and capital needs; the filing cautions that FFO is not cash available for distributions.