Empire State Realty Trust Inc

NYSE:ESRT

Earnings Call Transcript 2019-Q2

[Operator]

Greetings, and welcome to the Empire State Realty Trust Second Quarter 2019 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Mr. Greg Faje, Director of Investor Relations for Empire State Realty Trust. Thank you. You may begin.

[Greg Faje, VP, IR]

Good morning. Thank you for joining us today for Empire State Realty Trust's second quarter 2019 earnings conference call. In addition to the press release distributed last evening, a quarterly supplemental package with further detail on our results and our latest investor presentation has been posted in the Investors section of the company's Web site at empirestaterealtytrust.com.

On today's call, management's prepared remarks and answers to your questions may contain forward-looking statements as defined in applicable securities laws, including those related to market conditions, property operations, capital expenditures, income and expense. As a reminder, forward-looking statements represent management's current estimates. They are subject to risks and uncertainties, which may cause actual results to differ from those discussed today. Empire State Realty Trust assumes no obligation to update any forward-looking statement in the future. We encourage listeners to review the more detailed discussions relating to those forward-looking statements in the company's filings with the SEC.

Finally, during today's call, we will discuss certain non-GAAP financial measures such as FFO, modified and core FFO, NOI, cash NOI and EBITDA, which we believe are meaningful in evaluating the company's performance. The definitions and reconciliations of these measures to the most directly comparable GAAP measures are included in the earnings release and supplemental package, each available on the company's Web site.

Now, I will turn the call over to John Kessler, President and Chief Operating Officer.

[John Kessler, President and COO]

Good morning. Thank you, Greg. Welcome to our second quarter 2019 earnings conference call. At Empire State Reality Trust, though it is not that popular these days we are a New York City focused office and retail REIT with fully modernized assets, central locations and easy access to mass transit.

Our four drivers of growth deliver embedded upside and peer-leading cash leasing spreads. Our portfolio is well positioned, priced between trophy/class A and class B properties, to outperform in any market. We have a fortress balance sheet with significant cash, undrawn line of credit and low leverage. And we are an industry leader in sustainability and energy efficiency.

Today, Tom Durels will speak about the second quarter's approximately 261,000 square feet of leases, market demand for our properties and our market-leading leasing spreads. For our discussion of financial performance and our balance sheet, we will hear from Greg Faje as we all know from our prior filing, our CFO David Karp’s last day is a week from today and David is here with us and has signed off on all our numbers for the quarter.

As part of our transition plan going forward, Greg will be our lead with investors and analysts and he will report to me. And today he assumes David’s prepared remarks role for the call. Then, David will say a few words. And finally, Tony Malkin, our Chair and CEO will provide some comments on David and our CFO transition.

As always, we also have with us in the room Drew Prentice, our Chief Accounting Officer and Treasurer who will surely as per our filings be our Acting CFO; and John Hogg who many of you know our Head of Financial Planning and Analysis.

I’ll now turn the call over to Tom Durels. Tom?

[Thomas Durels, EVP, Real Estate]

Thanks, John, and good morning, everyone. In our second quarter numbers we made more progress on our four drivers of top line, derisked and embedded growth. The breakdown of these top line revenue growth drivers as of June 30, 2019, over the next five years we estimate to be $96 million can be found on Page 7 of our investor presentation. For reference, this compares to $543 million in trailing 12-month cash rental revenue and $386 million in trailing 12 months cash NOI as of June 30, 2019.

In the second quarter, we signed 55 new and renewal leases totaling approximately 261,000 square feet. This included approximately 175,000 square feet in our Manhattan office properties, 53,000 square feet in our Greater New York Metropolitan office properties and 33,000 square feet in our retail portfolio, which included 27,000 square feet of parking garage space.

Significant new office leases signed during the quarter include a 26,000 square foot new lease at 111 West 33rd Street with The Interpublic Group and a 21,000 square foot full floor new lease with L’Occitane, also at 111 West 33rd Street. In addition, we leased 14 new pre-builds or 81,000 square feet predominately at One Grand Central Place, 1350 Broadway and 111 West 33rd Street.

As a reminder, on Page 9 of our supplemental, we maintained updated disclosure on potential vacates and renewals for leases that expire for the remaining two quarters of 2019 and full year 2020. This chart shows tenants to be relocated within our portfolio and vacates to be replaced by new tenants with whom leases have been signed.

We have continued with our proven strategy to vacate and consolidate spaces, redevelop them and re-lease those spaces at higher rents to better quality tenants. There is a delay between the move out of existing tenants and the commencement of replacement leases and a further delay between lease commencement and GAAP revenue recognition, so our occupancy varies quarter-by-quarter and delays impact our near-term reported revenue.

During the second quarter, rental rates on new and renewal leases across our entire portfolio were 12.2% higher on a cash basis compared to prior cash escalated rents. And at our Manhattan office properties, we signed new leases at a positive cash rent spread of 22.2%.

Now, of course, leasing spreads always depend on the expiring fully escalated rents. Our vacant redeveloped office space had prior cash fully escalated rents of $53 per square foot, which is well below current market. On Page 28 of our investor presentation, we estimate our future cash leasing spreads on Manhattan office leases will vary between 12% and 24% based on the assumption of current market rents without any increase.

We have raised our weighted average asking rents in our Manhattan office buildings by over 4% on a trailing 12 months basis following increases throughout 2018 and demand for our product, location and price points remains good.

As we show on Page 12 of our investor presentation, our trailing 12 months net effective rent growth on a year-over-year basis for new Manhattan office increased by 6.2%, the third straight quarter in which we have experienced net effective rent growth in excess of 5%.

We have a healthy pipeline of leases in negotiation across the portfolio for both full floors and pre-builds. We remain focused on our strategy to vacate and redevelop space that we will bring to market for future lease-up.

Now, I will turn the call over to Greg Faje. Greg?

[Greg Faje, VP, IR]

Thanks, Tom. For the second quarter, we reported core FFO of $65 million or $0.22 per diluted share. Cash NOI was $94 million, down approximately 3% from the prior year period. Excluding the Observatory results on which I will comment momentarily, cash NOI was flat.

On Page 6 of the supplemental, we had added a new disclosure in response to helpful comments from the investors and analysts. This new quarterly schedule of commenced leases in their free rent period provides visibility to when the cash contribution’s NOI is realized.

Also, for your models, note our property operating expenses will be impacted in the next two quarters by one-time R&M expense associated with our quinquennial, Local Law 11 and tower work at the Empire State Building. These expenses are expected to total approximately $5 million in the second half.

Page 16 of our supplemental highlights our Observatory operations. Revenue for the second quarter of 2019 decreased to $32.9 million or 6.6% from the prior year period. Four factors combined for this result. $3 million of reduced revenue related to the closure of the 102nd floor observation deck and bad weather offset by improved pricing and the shift of Easter to the second quarter.

Net operating income for the Observatory was $24.5 million or 10.9% lower than the second quarter of 2018, due to the aforementioned revenue drivers and higher expenses relating to the Observatory redevelopment. Our present schedule is to open the new gallery on the second floor on the 29th of July, the new 102nd floor in September and the new 88th floor, the final phase, in November.

Excluding the second quarter 2018 102nd floor revenue but including the benefit of the entire Easter holiday during the second quarter of 2019, revenue increased 2.3% year-over-year and NOI was flat over the same period.

As reported on Page 16 of the supplemental, the Observatory hosted approximately 968,000 visitors in the second quarter of 2019, a decrease of 81,000 visitors compared to the second quarter of 2018. Of this 81,000 decline, we estimate that bad weather days resulted in approximately 67,000 fewer visitors in the prior year period.

In addition, we estimate that the shift in the Easter holiday which fell entirely within the second quarter of this year and in the prior year was split between the first and second quarters, results in a benefit of approximately 20,000 visitors. That leaves 34,000 fewer visitors attributable to other factors.

For the six months ended June 30, 2019, Observatory revenue decreased to $53.4 million or 5.3% from the prior year period due to a similar mix of factors I just mentioned. Net operating income was $37.5 million, 9.4% lower than the prior period. Excluding the 102nd floor revenue in 2018, Observatory revenue was roughly flat and NOI was down 2.5% over the same period. The Observatory hosted 1.57 million visitors in the first half of 2019, down 7.3% compared to the 1.69 million in the prior year period.

Moving to our balance sheet. As of June 30, 2019, we had total debt outstanding of approximately $1.9 billion and no borrowing under our $1.1 billion unsecured line of credit. The debt has a weighted average interest rate of 3.84% and a weighted average term to maturity of 7.6 years. None of our outstanding debt has variable rates. Our debt maturities are well laddered and our $250 million exchangeable bond matures this August 15.

We plan to retire the debt utilizing some of our existing cash in our balance sheet and we continue to consider our options to replenish the cash balance in the fourth quarter of 2019 with long-term fixed rate financing for many of our following options; bank term loan, private placement, public bond offering or secured mortgage financing.

As of June 30, 2019, our consolidated net debt to total market capitalization was 23.6% and consolidated net debt-to-EBITDA was 3.9x. And we held cash, cash equivalents and short-term investments of $525 million.

I would now like to turn the mic over to David. David?

[David Karp, EVP and CFO]

As per our press release on the subject, next week I will step down from my responsibilities as CFO and return to the West Coast. I joined ESRT back in November 2011 and I take pride in the role I played in our company’s IPO, the creation of our extraordinary balance sheet and the accounting, financial planning and analysis and investor teams I built here.

To our investors, vendors and sell-side analysts, I’ve enjoyed our collaboration in the time we’ve spent together. I’m particularly proud just knowing that some of you can now tell the difference between an IPA and a farmhouse AR. So with that, I will say thank you and I look forward to when our paths next cross.

Now, I will turn the call over to Tony for some remarks before we open the call for your questions. Tony?

[Anthony Malkin, Chairman and CEO]

First of all, on behalf of our Board and leadership team, we all want to thank David for his service to ESRT. You all know and we here all recognize that a company is run by a team and ESRT is no different. Our great team here has worked together and will continue to work together to maintain our low leverage, liquid and flexible balance sheet. We look forward to continue our excellent relationships with our investors, lenders and analysts.

The accounting team led by our soon-to-be acting Chief Financial Officer, Drew Prentice; the Financial Planning and Analysis team led by our two and a half decade veteran, John Hogg; and Investor Relations team led by Greg Faje will all be guided by John Kessler as we move through our transition to a new CFO.

We have engaged Korn Ferry International in a search for our next CFO and we have tremendous inbound interest in the position from outside the company and interest from within. We thank David for his leadership and contribution and wish him the best of luck out there in California and Oregon.

Now, let’s turn the call over to the operator for Q&A.

[Operator]

Thank you. At this time, we’ll be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from the line of Jason Green with Evercore ISI. Please proceed with your question.

[Jason Green, Evercore ISI]

Good morning. Given where the stock sits today and what seems to be an inability to find an acquisition in the marketplace that makes sense, has there been any change in thinking surrounding buybacks?

[John Kessler, President and COO]

Good morning, Jason. It’s John. No, I think our view on buybacks continues to be where it was in the past. As you know, we’re focused on trying to grow the business rather than shrink it. And deploying capital into a buyback reduces our share count, et cetera. We have the balance sheet that we’ve constructed, the cash and liquidity for a purpose which is to create optionality for the future and for growth and that continues to be where our mind is at.

[Jason Green, Evercore ISI]

Okay. And then I guess beyond bad weather days, what are you guys seeing in the general tourism market that potentially might be driving visitation down at the Observatory? Thanks.

[Anthony Malkin, Chairman and CEO]

Well, I would say – Tony here. The competitive landscape for destination attractions has been very challenging in general. The performance has been across the board quite sketchy when I look at everything from One World Trade Center which is down to 33% from last year through our vendors who we share and which is our only source of input vendors, meaning folks who sell our tickets and in common with other venues. We know we’re outperforming on Top of the Rock, though we don’t have a full picture of their performance the way we do from One World Trade. We know that Circle Line and some other attractions are down public announced numbers for the first six months of 2019 show the Metropolitan Museum and some other museums down. And at the same time, you’ve got Hudson Yards that is opened which initially reports folks tracking cell data upwards of 70,000 people a day on weekends. Now that same cell data reports less than half that number per day. I think we should anticipate that the noise from competing transactions including [indiscernible] press and advertising around them and tourist trends will continue for some time. We did see this with the opening of the 911 Memorial Museum and One World Trade Center and even the reopening of the Top of the Rock. I said we’ve always grown revenue. I think it’s a moment just to say a couple of words about the redo of the Observatory that has set the table as to where we are and to give you guys an expectation of what we’re going to be doing. Phase 1 which was the new Observatory entrance opened in August 2018 and has already increased the desirability of our 34th Street retail space availability and cleaned up our 5th Avenue lobby and 5th Avenue experience for tourists and office users alike. Phase 2 which are our new galleries on the second floor will open on the 29th, this Monday, 29th of July. And I have to say that you’ll have to see it to believe it. But it is extraordinary. Phase 3 which is our complete redo of the 102nd floor will open by the end of September. Phase 4 which is our complete redo of the 80th floor will open by the end of November. So there’s nothing like the Empire State Building and there’s nothing like we will deliver here in the world, period, full stop, no exceptions. We’ve all done this work while operating the Observatory. This is truly impressive by our ESRT professionals and outside creative and execution team. And if you add to that the fact that we have had scaffolding up for our quinquennial, Local Law 11 work, it has not been simple to move millions of tourists in addition to all of the contractors and laborers and trades and creative folks that we’ve had in and out of the Observatory. So just to shine a little light on the Observatory, I think it’s just worthwhile to note and there’s going to be noise out there, number one. And number two, we full well recognize that we’re executing at a very high level on the office. We are delivering, Tom Durels will be able to go into it, great trailing 12 months net rent growth. We are delivering fantastic credits on long-term leases to our buildings, very busy. But we’ve had a significant hurdle to overcome which we have which was the reduction in our broadcast income. And we know that if the Observatory doesn’t deliver that a lot of that great result on the office leasing isn’t going to show. So the Observatory we’re excited for the opening. The competitive landscape is all over the place. Don’t forget we had – as you know, we had heinous weather, the worst in years for the first half of this year. If we adjust for the closure of 102nd observation deck, second quarter revenue was up 2.3% last year and first half revenue was flat and our per caps on trailing 12 months was a 6% increase versus last year. That said, there will be a lot of noise coming for the upcoming period. And I’m sorry if I’ve gone on too long, but I figured I’d answer a lot of questions about this all at once.

[Jason Green, Evercore ISI]

No problem. Thank you.

[Operator]

Thank you. Our next question comes from the line of Craig Mailman with KeyBanc Capital Markets. Please proceed with your question.

[Craig Mailman, KeyBanc Capital Markets]

Hi, guys. I’ll start to say David congrats and best of luck with the next phase and thanks for all your help over the years. Just want to hit on the cash NOI growth in the quarter. I guess maybe Greg or David, could you guys just walk me through? I would have thought given kind of the conversation last quarter about the 3 million that would kind of flow through more so in 2Q than a little bit more on top of that that we may have had kind of a bigger pickup this quarter. Could you just kind of talk about the puts and takes that may have kind of offset that on the margin?

[Greg Faje, VP, IR]

Sure. This is Greg here. If you look on a sequential basis, we did show some property cash NOI growth of about 3%. And if you look more closely at the cash rental revenues, they increased about 1.3 million on a sequential basis from first quarter to second quarter. This increase consisted of two parts really. If you hit approximately 3 million in free rent burn-off and that was partially offset here by 10 vacates of about 700,000 and holdover rents that occurred in 1Q, in the first quarter, of about 600,000 and a few other small miscellaneous items.

[Craig Mailman, KeyBanc Capital Markets]

Okay. So at the way it looks, we should still – it looks to be more 2020 kind of ramp at this point just because occupancy is going up but on a cash basis you’re probably not going to get until next year given kind of the enhanced disclosure you guys gave?

[Greg Faje, VP, IR]

Yes. I think if you look at the new schedule that you saw there on Page 6 that gives you a little more clarity in terms of the timing as it comes in quarterly. We’ve put that in there specifically to help people model it better. And then you’ve got the vacate schedule on Page 9 that I would also – you have to look at that in terms of the offset that you’ll see over the course of '19 and in early '20.

[David Karp, EVP and CFO]

The only thing I’d add to that is look, we are always opportunistic to generate additional revenue where we can from existing tenant lease. If you look at the underlying recurring business, it’s actually doing very well. We had other income from other tenant-related transactions and we’ll always do that to the extent that we really prefer to do direct leases with new tenants than enable subleasing. In our spaces, we like to get tenants to buy their way out of leases which produces extra revenue and covers our cost of re-tenanting rather than let the market pick up the scrape of the discount. And so that can distort the excellent performance we’re achieving on a recurring basis.

[Craig Mailman, KeyBanc Capital Markets]

That’s helpful. And maybe Tony just thoughts here. The commentary today has been good. The results have been good on the net effective rent growth side, the occupancy side but yet the stock still trades at a pretty wide discount here in New York; last time I checked still a pretty global market. So I’m just curious on your thoughts overall kind of what you think you guys need to do or the market needs to understand on the disconnect here between public and private values and fundamentals versus sentiment?

[Anthony Malkin, Chairman and CEO]

First of all, I very much appreciate your question because it gives me a chance to explain to Jamie Feldman that I do more than just the Observatory. Second of all, I think there are a few things which really stand out. Number one, there’s a reason we went public and the reason we went public was to resolve a series of antiquated partnerships and limited liability companies bringing modern government structure and a unified balance sheet and make things more efficient. And that process was difficult. We’re glad we did it. If I sit down with other brethren in the REIT business right now public companies, brethren and sistren, I would say, I would say that there’s a – a common refrain that I hear is the reason that your public just to be able to access capital markets and the discounts in which we’re trading, we can’t access capital markets so why should we be public. I think that speaks to two things. One, we don’t need to access capital markets right now to grow externally. We’ve got a great balance sheet, a lot of liquidity, great access to additional cash through our line and that we have low leverage. So I’m very mindful of the general scale [ph] that you hear from the CEO side and how we’re differentiated there. I’d also say I had something put together for me by Greg Faje which takes a look at the different REIT sectors and their premium or discount to NAV as determined by Green Street whether that’s accurate or not, it’s a consistent measure on July 2017 and compare it to July 2019. And we had the lowest discount in our peer group in July 2017 and we were trading at a slight discount, a single digit discount. If you look at that same chart today to July 2019, office REITs are down there with malls. But if you blow open that office sector, you’ll see the bottom four properties are all New York City based REITs; SL Green, Vornado, Paramount and ourselves and we still have the lowest discount to that NAV. That being said, being the loudest mute [ph] in the choir, it’s still a difficult spot in which to be. And there is no question that while we’re focused on external growth, we have to look at that massive disconnect between what the private equity flows are and how that’s driving values in the market and where we are as a public company. So first of all, while we’re not exercising it now, everybody knows that we’ve got a buyback privilege. We have that right and we made that capacity bigger the last time we reviewed it. Number two, we’ve got a balance sheet which would allow that to occur should that something we want to pursue. When we look at a bigger picture and the things that we have to do, we have to continue to execute as an office and retail primarily New York focused REIT, we have to continue to execute at a high level. We have to address the Observatory, which we’re doing which we saw three and half years ago and all that work is coming to fruition now. And then I think you’re right. We have to have existential conversation amongst the executive team and with our Board on a regular and recurring basis which is what we do which is how should we be positioning ourselves as a public company, what’s the best way to deliver long-term value for the shareholders, how do we drive the bottom line? And in that I would just tell you that we always look at every option and we try not to do it daily because it gets in the way of executing our regular tasks. But we look at every option. It’s a robust conversation. And the question you’re having is something that we answer with a variety of options which we weigh every time we get together with our Board.

[Jordan Sadler, KeyBanc Capital Markets]

Hi, Tony. It’s Jordan Sadler here with Craig. I had just one follow up on sort of the buyback, because John in response to the initial questions that you guys want to grow the company and not shrink the capital base, which is understood, but your cost to capital is quite high as implied by the market. Would you guys invest opportunistically in assets today at returns that are lower than those that could be garnered by just buying your stock?

[Anthony Malkin, Chairman and CEO]

I think that if you would look at it at a current return with a prospect of improvement over time, the answer to that would be yes. I think if you were to look at buying 540 Madison Avenue at a 4.5 unlevered IRR, at least how we underwrite it, or 477 Madison at a similar number for a lesser asset or I can run down a list of other transactions which have taken place in New York City, the answer is no way. It’s absolutely better to have either the flexibility or to increase our return per share. But don’t forget, we still have that $96 million or so of top line growth which we’re driving our embedded growth drivers. We still believe that – look, when you start to see the articles out there explaining why this economic cycle justifying and rationalizing why this economic cycle is virtuous and will never end, every time those articles have popped up, it’s a sign that the thing’s pretty close to ending. Those articles are popping up. We’ve got tremendous deficits. In the government, we have tremendous unfunded state liabilities. We have a trade war with China which is impacting tourist visits along with flows of capital, sales of homes, you name it. We have a world in which the Europeans are talking about lowering their interest rates again. We’ve got negative spreads in Europe and in – negative to zero [indiscernible] Europe and Japan. At some point at some price I would imagine given the alternatives, we could find ourselves in a position where we would say it makes more sense to buy our stock than to do anything else. But right now I think John very correctly and succinctly expressed our view.

[Jordan Sadler, KeyBanc Capital Markets]

Okay. Thank you.

[Operator]

Thank you. Our next question comes from the line of Blaine Heck with Wells Fargo. Please proceed with your question.

[Blaine Heck, Wells Fargo]

Thanks. Good morning. Tony or John, just to expand on the investment picture, can you give any color on whether you guys are pursuing anything right now and whether there are specific opportunities for the kind of challenged assets or unique situations that you’ve talked about before?

[John Kessler, President and COO]

Hi, Blaine. It’s John here. We do look at actively what is out there in the market and I think what – and maybe echoing back to the prior question, I think how would we deploy capital? I think you can see that we haven’t, right. We haven’t made any investments in the current environment because of the super low returns that we’re seeing that investors are getting in the private market because there’s so much capital there. I think what we’ve continued to see is whether it is a income in place or a core deal or a redevelopment or value-add situation that the market continues to price it aggressively. And to date we haven’t found anything that’s attractive to us and I think we haven’t seen that change. We’ve also seen – it seems like certainly the smaller transaction sizes also there’s even more liquidity and they’re more aggressively priced.

[Blaine Heck, Wells Fargo]

Okay, that’s helpful. And you guys obviously have the relationship with QIA. They have the right of first refusal on any JV you guys might like to do. So I’m assuming you guys have regular discussions with them. Can you give us any sense of their appetite for investing in New York office at this point?

[Anthony Malkin, Chairman and CEO]

First of all, we are fortunate to maintain a very good and close relationship with our Qatari partners and these are excellent people with a long-term view. They’ve been terrific partners. Second of all, I think it’s no secret to know that they still have capital to invest and they played a large role in the Tornado joint venture providing half of the new equity that went into the new capitalization of the retail on which they did transact and wrote a big check. They have the ability to write big checks. I think that it’s also very clear. These are smart, long-term thinkers and they are willing ready and able to participate in anything where we present a compelling case. And we talked about this often. The reality, however, is we haven’t added anything where we’ve been able to present to them a compelling case. And we’re not a private equity operation where we’re seeking to aggregate capital, collect fees and get a hope certificate for optionality for upside in the future. So we take our partnership with them very seriously. We treat it with the highest respect and regard. And we know that if we discuss things with them, we have their ear. And if there are things which we advocate, we have a very high level of confidence that they will participate. As far as their interest generically and what they might do, I’m not in a position to comment on that. It’s best to ask them. Just they remain very engaged with us. And when we discuss ideas with them, which we have where we’re trying to rub two sticks together and create value for our investors, they’ve been very supportive.

[Blaine Heck, Wells Fargo]

Okay, that’s helpful. Then lastly, Tom, we noticed you guys added a 28,000 square foot intentional vacate in 2020 to the retail portfolio, small in size but for the retail it’s kind of big. Can you just give some color on that decision and where that space is?

[Thomas Durels, EVP, Real Estate]

Well, the vacates in 2020 primarily relate to Heartland Brewery whose lease expires in early 2020. As a reminder, they occupy about 17,000 square feet. They occupy the corner 34th and 5th at the base of the Empire State Building. We view this as a great opportunity for us to enhance the experience in the retail at the base of the Empire State Building. We are actively marketing that space. And then we added some side street retail in 501 Seventh Avenue occupied by some legacy garment tenants. We just think we can bring in a better type of tenancy to provide amenity in services to our office tenants. So those are primary drivers of the vacates in 2020 for retail. But while on the topic of just the planned and known vacates and potential vacates, on the office side whether it be the tenant vacate, the intentional vacate or the unknowns, we have space that represents great upside opportunity for us. There are floors that we will be getting back or potentially getting back that include tower floors at Empire State Building with fully escalated rent at an average of $39 per square foot. We have full floors at 1400 Broadway and 501 Seventh Avenue also with in-place fully escalated rent of 39% a square foot. These are well below market. We’re anxious to have the opportunity to re-lease those spaces at significantly higher rents.

[Blaine Heck, Wells Fargo]

Great. That’s helpful. David, thanks for your help over the years and enjoy that West Coast beer.

[David Karp, EVP and CFO]

Thanks, Blaine. I appreciate that.

[Operator]

Thank you. Our next question comes from the line of Emmanuel Korchman with Citi. Please proceed with your question.

[Michael Bilerman, Citi]

Hi. It’s Mike Bilerman here with Manny. Tony, I wanted to come back to the buyback program, just understand sort of the Board’s perspective in authorizing the buyback last October which was 500 million. The stock at that time let’s call it $16 to $17. Over the course of the last nine months, it’s been anywhere down from 10% to 15% from those levels. So I have to imagine that when you put it in place, there was some expectation that the stock represented decent value at that point. And I understand that you want to have liquidity and you want to keep the balance sheet fresh. But why put one in place and then not even execute any of it even modestly at values that I would imagine you and the Board felt very comfortable when you put it in place as a tool and probably feel even more compelled now that it’s 10% to 15% lower than that value?

[Anthony Malkin, Chairman and CEO]

Sure. Thanks, Michael. I look at this in two ways. First, just by way of background, if you recall at the time we put this into place, we did announce that we had already had a buyback authorized. And what we did with this authorization is recognize that we were going into a new territory not just for us as a public company but for the New York City office sector in general. And we decided that we wanted to make that authorization two things; one, bigger and number two, public. And the reason we wanted to make it bigger was to make sure that we could take advantage of opportunity should things really fall out of bed altogether. And number two, we wanted to make it public because our plan is if we were to execute not to do it in drips and drabs to support the stock price but to do it frankly quietly and stealthily to acquire and aggregate value for ongoing investors as opposed to selling investors. With that in mind what we’ve discovered through advice from counsel is if we didn’t make that fact that we had a buyback program in place public, we could be exposed to litigation should we execute in that quiet and stealthy fashion. And having spent decades in litigation with various parties, I really have no interest in entering into that again in my lifetime. So it was a prophylactic measure. The second thing I would say is we look at ourselves not just in relationship to our value relative to our stock price but we look at our stock price in relationship to peers with whom we might like to conduct M&A activity in New York City. And they’re all trading at bigger discounts than we are. And the fact is that we look at that relative value merger opportunity as a meaningful outlet for us which we have regular discussions internally and which we – again, I’m trying to rub two sticks together. We want to leave the option open for that. So instead of just looking at our balance sheet and our stock price and our net asset value, I look at our balance sheet, our stock price, our net asset value and the surrounding environment. And that’s where I say, what’s the major distinguishing factor between us and the rest is we have a lot of cash and a lot of leverage ability within our balance sheet both to transact and to assist others with problems that might develop with liquidity on their watches in case of further disorientation. So when we have these discussions at the Board level and the Board is 100% aligned with management and management is 100% aligned with the Board, we look at that second factor very carefully. And again, on the first part of the response, we made that change as far as size and going public just to protect ourselves and increase our flexibility.

[Michael Bilerman, Citi]

And then when you think about M&A putting aside public to public, I think one of the big things you’ve always talked about since the IPO process was the relationships that you and your family had with a lot of private owners that owned assets, not just office assets but other property types within the New York and metro area and that the ability to provide units to those holders that can buy into the Empire State Realty Trust was an advantage. And given where your stock is, can you talk a little bit about how those negotiations or those discussions have been going because one would assume that it’s a little bit more challenging given where the current stock price is relative to what you perceive as NAV value?

[Anthony Malkin, Chairman and CEO]

You’re a master of understatement there, Manny --

[Michael Bilerman, Citi]

It’s Michael.

[Anthony Malkin, Chairman and CEO]

Oh, it’s Michael, okay, sorry. Well, then Manny you’re silent and Michael you’re master of understatement. I would say that when you look at 477 Madison which is slumpy, low ceiling, clear height, half block frontage on a – with best of retail because the Madison Avenue goes downhill there, so it’s not even a retail frontage. You’re next to St. Pat’s Cathedral and the Palace Hotel. So when you look at these things and you say that building – functionally when you look at the purchase price and what they have to spend on it, it’s easily $1,000 a foot. And when you look at that and the rents that can be achieved there and the operating costs and real estate taxes, you say to yourself wow, every single private owner of office in New York City assumes her or his value or her or his asset on a transaction is worth between $850 and $1,200 a square foot. And if there’s a slight difference between the public value and the private value, it’s a much easier bridge that you have to take to get over that gap of value. That being said, we still firmly believe in the conversations we have. We’d like to highlight that if there’s a next gen which is not capable, if there’s a next gen which has such diffuse interest as far as continuing to receive distributions, wanting to increase distributions or wanting to cash out, if there’s a next gen which has disputes as to who’s in charge, we are a terrific solve. I would make one other comment. It’s not just the prices at which these properties are trading but it’s the availability of debt. We know of one family that has a property which is going to go 100% vacant with an over market or nearly at market lease. It has debt maturing at the same time as the vacate. It has no depth to execute on an improvement program confronting the New York City 80 x 50 laws with regard to energy consumption and greenhouse gas coefficient carbon output. They’ve got proposals to take out their expiring, retiring maturing loan and fund all of their improvements based on speculation and no new tenant. And so the availability in debt markets, the availability in capital markets there’s no question it makes our task harder. It doesn’t daunt us, doesn’t stop us but it definitely makes it harder.

[Michael Bilerman, Citi]

Just last thing, the buyback does expire at the end of this year. At what point do you reauthorize that and is the intent just to let the 500 million flow for another year? What’s the process and discussion going on at the Board level for that?

[Anthony Malkin, Chairman and CEO]

Let’s put it this way. I can’t talk about the future but I can talk about the current and the past and our view is and our view has been – when I say our that means management and the Board that having stock buyback authorizations because let’s not forget there are a couple of different ways under which one can buy back stock we believe is very important to have this in place. And it’s an option, an arrow in our quiver, and want to make sure it’s in there.

[Michael Bilerman, Citi]

Right, just an arrow but you haven’t been able to take it out and doesn’t sound like any intent to take it out anytime in the future?

[Anthony Malkin, Chairman and CEO]

Well, any time in the future is a long way. I would say that we haven’t seen a reason to do it yet. I would say that standing here today or sitting here as we are, we absolutely have a specific price at which we would act. There is no question in that. At the same time, if we were to get that and find out that every other New York City based REIT stock moved in concert with ours, we would look at that along with our own stock price and coming to a decision. But right now I can tell you for sure that there is a number at which the Board and we have agreed we would act.

[Michael Bilerman, Citi]

All right. I think if you look SL Green I think from that perspective, they’re selling assets in NAV and buying their stock back at a discount. Inherently they’re creating NAV value and real estate value. Arguably what’s going on in the macro environment and New York is clearly affecting all of your stock prices but just purely from a capital allocation perspective using that capacity, selling assets, selling interest and assets at market value which there’s a large and liquid market that you’ve just talked about and then buying back that stock at some level of a discount creates value, right. It’s just math. You can’t argue with it. So it seems as though that strategy would be a good one.

[Anthony Malkin, Chairman and CEO]

Look, SL Green spent a lot of money and their average buyback price is materially in excess of where their stock trades today.

[Michael Bilerman, Citi]

But I wouldn’t look at the stock price as being the measure of success, I would look at the value creation in terms of selling assets in NAV and buying back stock below it. Where would their stock be if they hadn’t done that, where would their NAV be if they didn’t do it, right? It’s pure capital allocation. In hindsight, yes, one would like the stock to be higher but selling assets add NAV value and buying stock back at a discount to that value creates value absent doing nothing. So I’ll let the call go on. Thank you.

[Anthony Malkin, Chairman and CEO]

Thanks.

[Operator]

Thank you. Our next question comes from the line of Jamie Feldman with Bank of America Merrill Lynch. Please proceed with your question.

[Jamie Feldman, Bank of America Merrill Lynch]

Great. Thank you. I guess just a follow up. Do you guys think at all about asset sales, especially in your core kind of New York Manhattan assets?

[Anthony Malkin, Chairman and CEO]

We’ve looked at this, Jamie, from the perspective that if we sell assets, particularly in our core locations in New York City and Manhattan, we have to look at a, what are we going to do with that money? And b, we have to look at it and say, we’re already a smallest company. And if we liquidate further, we will be a definitively smaller company. And at that point there’s not a lot that we can do which wouldn’t really just say either if we should liquidate the whole company or we shouldn’t sell anything. And when we look at selling assets or portions of assets, not only does that shrink the business but when you’re selling partial interest and taking in JV partners, we don’t have any of that right now and that gives us absolute flexibility to do whatever we want whenever we want. So again, we look at everything. We discuss everything. But what we’re doing right now is where we’ve come out after the robust discussions we’ve had to date.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay, all right. Shifting gears, you guys had talked about the debt maturity coming up in the back half of the year. Can you talk about – I know you talked about several different options to refinance. How should we think about the potential accretion or dilution from those different options or do you think it’s more a neutral for earnings?

[David Karp, EVP and CFO]

Yes. Jamie, it’s David. If you take a look at the existing exchange on a cash coupon basis, we pay back 2.625% and for GAAP purposes which incorporates the non-cash portion of the equity option and the amortization of the deferred financing costs, it’s around 3.9%. We have a swap in place we put in place a seven-year before [ph] starting interest rate swap which has a strike price of 2.958%. If you look at current spreads let’s just say on a seven-year term loan that’s running about 150 basis points. That would put us in an all-in coupon of about 4.5%. So on a cash basis, our interest cost would be about 190 basis points higher, which assuming a 250 million notional amount would translate into $4.7 million annually. On a GAAP basis, our incremental interest cost would be roughly 60 basis points higher which equates to roughly 1.5 million annually again on that same notional 250 million.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay. Because I think you guys listed several different options, it sounds like that’s your most likely option is to roll it into --

[David Karp, EVP and CFO]

Yes, I’m just giving you that as one example. But yes, we do have a number of options. We can do a seven-year term loan, we can do a private placement, we could enter the public markets and we could do a secured mortgage financing. So there are a lot of options to look at. I just gave you the term loan as one example.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay. So I guess if you were to think about the best case scenario, would there – which of those would actually be accretive or would they all be kind of at least neutral if not dilutive?

[David Karp, EVP and CFO]

They’re all roughly in the same ballpark and I think given that we have this swap in place of roughly 3% that’s going to be the driver. The spreads are going to be somewhat comparable across executions, so I think that’s really the difference.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay. And then Greg had talked about this R&M expense in the back half of the year. Can you talk more about that? And then if you look at your year-over-year expenses on the Observatory, they’re up meaningfully and in fact you compare the revenue decline year-over-year to the NOI decline year-over-year and it’s a much bigger hit. Can you just talk about the expenses in the quarter and then what to expect going forward?

[Greg Faje, VP, IR]

Yes. Jamie, this is Greg here. I’ll touch on the R&M and then I’ll switch back to David to talk about the Observatory. The R&M work is work related to Local Law 11 which is a five year – every five years you have to do that work and that’s primarily done at the Empire State Building.

[Anthony Malkin, Chairman and CEO]

Also known as quinquennial.

[Greg Faje, VP, IR]

As well as some work at the top of the tower there. We expect about 5 million of expense in the second half relating to these two combined.

[David Karp, EVP and CFO]

And on the Observatory expense, the year-over-year increase was really attributable to the higher IT expenses both maintenance and consulting which was associated with our new ticket kiosks and the entrance hardware and software. We had higher R&M expenses, we had higher marketing expenses and this was partially offset by lower payroll and benefits. But what I will point out is that we still anticipate the run rate on expenses to approximate what we experienced in the fourth quarter of 2018. As I said before, this anticipation is based upon early experience with the technology. And as the new systems in technology are stabilized, we’re going to have a better sense of what the run rate would be as the year progresses and we’ll communicate to you if we feel there are going to be any differences from that run rate. Lastly, just on the labor savings that we realized from the reduction of the cash is being somewhat offset by the higher technology costs.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay, so it comes down from the 2Q run rate and we should look at 4Q as an example.

[David Karp, EVP and CFO]

Yes, quarter-over-quarter there was an increase as well that was associated with some higher marketing which is timing related and higher security and credit card fees which is seasonality. So we’re always going to see some movement around the expenses for seasonality. We had the introduction of the new software. But when we look at our expectations, I think a good run rate is what we saw in the fourth quarter of 2018.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay. And then Tony had commented about some of the signs he’s seeing that gave him a little bit of concern that we’re late in the cycle in one of his responses to one of the questions before. I’m just curious. Are you guys seeing any kind of shift in tenant behavior whether it’s the types of tenants you’re seeing leasing space or their willingness to go long or short or anything that’s kind of telling you based on prior cycles that something’s changing as well?

[Thomas Durels, EVP, Real Estate]

As far on the leasing front – this is Tom by the way. On the leasing front, we’re not seeing any change in the market that would indicate that we’re late in this cycle. I would say that we feel great about the pipeline of activity we have in our office space. We’ve got leases and also in negotiations for full and partial floors at 111, 1400, 1333 and 250. We’re seeing demand across all of our properties for both pre-build and full floors from a variety of tenant types that includes tech, TAMI, consumer product, professional services and other. And as I pointed out in my earlier comments, look at the net effective rent growth that we posted or our actual trailing 12-month net effective rent growth on a year-over-year for new Manhattan office leases increased by 6.2% this quarter. That’s a third straight quarter in which we have experienced net effective rent growth in excess of 5% for new leases in our Manhattan office properties. As a generous reminder, that’s on Page 12 of our investor presentation. And we’re seeing a lot of leasing that we’re doing does involve employment growth. So all of these are good signs. We’re not seeing any change at least out on the street on the frontlines where we’re doing leasing.

[Jamie Feldman, Bank of America Merrill Lynch]

Okay, that’s helpful. All right, David, good luck in your next chapter. It’s been a pleasure working with you.

[David Karp, EVP and CFO]

Thanks, Jamie. As with you.

[Jamie Feldman, Bank of America Merrill Lynch]

All right. Take care.

[Operator]

Thank you. Our next question comes from the line of John Guinee with Stifel. Please proceed with your question.

[John Guinee, Stifel Nicolaus & Co.]

Great. Thank you. Well, I’m worn out from the theoretical share buyback conversation. David, we are going to miss you. You do know that in California they only drink wine, they don’t drink beer.

[Anthony Malkin, Chairman and CEO]

That’s why he’s going to spend half his year in Bend, Oregon.

[John Guinee, Stifel Nicolaus & Co.]

So dealing with the more mundane day to day stuff here, your Page 6, Page 9 analysis or comparison is incredibly helpful and if I look at the cash gains for commenced leases in free rent, I come up with – you come up with about $29 million. And then if I look at the rest of this year and next year and I look at the tenant vacates and the intentional vacations, I get about 570,000 square feet and at your in-place rent that equates to about $30 million. So is this just kind of a Yin Yang where all the leases about to commence are offset by the rollouts in the next 18 months or is there a chance that we see some NOI growth?

[Greg Faje, VP, IR]

Hi, John. This is Greg here. We do give these schedules here to help you out and as you noted we give the new schedule on Page 6 that gives you a little more clarity into the timing there. And I think it’s important to look at that as both the vacates we give on Page 9. And just from a growth perspective we do have 102nd floor observation floor that’s currently out of service and we’ll come back online at the end of September. And a few other factors that have sort of created these headwinds here in 2018 that we discussed previously in terms of leasing costs that are previously capitalized are now being expensed. And so as we look forward, we expect to see some growth.

[David Karp, EVP and CFO]

And the other thing that’s important and why we went to the quarterly representation is that the timing of both the vacates and the burn-off of the free rent are important when it occurs. If you just took a convention mid-quarter or midyear, it might distort what is really expected to happen. So I’d take a closer look at the quarterly breakdown and that might help you fine tune your model.

[Thomas Durels, EVP, Real Estate]

John, this is Tom. Just one additional comment I’d like to make on that is just remind you we are intentionally vacating space to unlock the value creation through mark to market increasing rents. As I pointed out earlier, we have a number of spaces that either we’re intentionally vacating or that if the tenants chose to vacate, we will re-lease those spaces at significantly higher rents because the in-place rents are significantly below market. So we view this as an upside opportunity.

[John Guinee, Stifel Nicolaus & Co.]

Tom, a great segue. Everything I read about Stamford, Connecticut and the New York suburban markets in that vicinity is pretty scary. Can you talk about the suburban market and the ability to re-lease this product given your $40 million capital spend? And then also a curiosity question. Heartland Brewery 17,000 square feet, will that be a roll up or roll down in rent and what kind of capital do you think you’d have to expend there?

[Anthony Malkin, Chairman and CEO]

So let me first hit upon the Greater New York Metropolitan portfolio. As a reminder, we’re just about 89% leased and we did do 53,000 square feet of leasing this quarter as you mentioned, as previously announced we’re underway with an upgrade of the [indiscernible] areas and amenities, improvements to our gyms, dining, creating new coffee lounges, conference centers, lobbies and outdoor areas. And the work that we’ve completed so far looks great. We’ve received very favorable feedback from brokers and tenants. We’re early in the marketing of some of the space that we know that we’ll be getting back. But as a reminder, we’ve got the best locations within each of our submarkets and we’re conveniently located in mass transit stations and intersections of major thoroughfares. Look, we’re confident in our offerings. And based upon the work that we have completed and the feedback that we’ve gotten, we’re quite confident. We like our locations and we like our product. Moving on to the retail, I will simply say that that corner space in Empire State Building is incredibly unique. We are focused on bringing the right use for this space that will enhance the experience for both our office tenants and Observatory guests. We’re working on it with some prospects right now, some very interesting and exciting concepts. So whether it ends up being an increase in rent or not, I think we’re looking at more holistically as to what it does for the Empire State Building and the Observatory and for office tenants in the overall experience. We just don’t think that the existing tenant does much for us right now.

[John Guinee, Stifel Nicolaus & Co.]

Holistic leasing, okay, great. Thank you.

[Anthony Malkin, Chairman and CEO]

You bet.

[Operator]

Thank you. Our next question comes from the line of John Kim with BMO Capital Markets. Please proceed with your question.

[John Kim, BMO Capital Markets]

Thank you. Congratulations to David, good luck. My first question is on occupancy. The highest occupancy you’ve had as a public company but at 90% there’s still room for an upside. Do you see occupancy growing from here or it’s just a blip? And with tenant move outs and so forth, it’s kind of stays or hovers around 90 or below.

[Thomas Durels, EVP, Real Estate]

This is Tom. Look, we’ve given a lot of information on Page 9 of the supplemental which details obviously our future rollouts. The amount of leasing that we’ve done to date – look at last year, we did about three-quarters of million square feet of new leasing in our Manhattan office portfolio. We had a very good quarter with 260,000 square feet of leasing. As we move into 2020, you can see just the amount of unknowns are shrinking and the amount of space that is targeted for redevelopment where we’ve completed about 7.6 million square feet, only have roughly 600,000 square feet left within the entire portfolio speaks to as we go forward less move-outs. Look, we give a lot of detail on Page 9. We’re confident in our ability to lease space. We’re active right now. We’ve got active proposals and leases in negotiation across the portfolio. As a reminder, look, the occupancy is going to bump around from quarter-to-quarter, but on an overall trend we feel confident where we’re headed.

[John Kim, BMO Capital Markets]

I’m just wondering some of your peers are let’s say 5% to 6% vacancy, I think the market overall is probably around 8% or 9% and you’re consistently above that as far as vacancy rates. But when do you get back to market or closer to your peers?

[Thomas Durels, EVP, Real Estate]

Look, as I said before, we’re going to continue to execute on our program to vacate spaces and consolidate smaller spaces in the larger offerings so that we can re-lease those spaces to better tenants at higher rents. The purpose of providing you the detail on Page 9 gives you our best look as to what we expect will happen through the end of 2020 as we work our way through the balance of the undeveloped space, we’ll be much more towards a stabilized portfolio.

[John Kim, BMO Capital Markets]

If I could ask the cash NOI contribution question in a different way and I appreciate the additional disclosure you have on Page 6. But at the beginning of the year you had $23.5 million of leases that will begin to contribute to cash NOI this year and I realize you’re not going to get all of that this year because of the timing of when those leases start. So for lack of a better word that’s a balance number. But on a cash flow basis, how much of that 23.5 million will you see contributing to cash flow in 2019?

[Greg Faje, VP, IR]

John, this is Greg here. If you look at the schedule on Page 6 there, it is as you pointed out, it’s a balance number, right. So you have to look at it as it gets realized over the course of the year. So if you’re using the December 31st number, we should realize 21 million over the course of the year and then the additional schedule that we’ve now added on Page 6 will give you some better sense to timing going forward, so this clarity will help you.

[John Kim, BMO Capital Markets]

That’s for 2019 or 2020.

[Greg Faje, VP, IR]

2019.

[John Kim, BMO Capital Markets]

Okay. And then final question maybe for Tony on the Observatory. All the additional exhibits and now the most will go [ph] on the second and 80th floor, how do you think this will impact revenue? Will it justify higher ticket prices or is it just really to make the experience better?

[Anthony Malkin, Chairman and CEO]

First of all, it’s absolutely I think important to differentiate ourselves from all the other Burj Khalifas that are being put up in the marketplace. Second of all, we have a uniqueness to us which is instilled in everybody’s mind, heart, you name it around the world. But finally I think and most importantly every single thing that has to do with offense is good for defense. This is offense and we’re definitely looking at a much better offering. Think of us as the only museum which is open from 8 AM to 2 AM seven days a week in New York City or in the world. It’s a museum level installation. Again, seeing it will be believing it. And we believe this will help us not only maintain but also our goal is to increase revenue. And by the way, the increased reasons to come to the building on bad weather days as well.

[John Kim, BMO Capital Markets]

But it won’t be a separate ticket price, right, but it’s just an all-in one price to see the Observatory and all exhibits?

[Anthony Malkin, Chairman and CEO]

That is correct. Although, of course, as you know, we do offer several different levels of experiences in our ticket pricing and there will still be the express opportunity to bypass everything and the quickest visit. This is part of “the ticket price.” You don’t do one or the other.

[John Kim, BMO Capital Markets]

Got it. Thank you.

[Operator]

Thank you. Ladies and gentlemen, that concludes our question-and-answer session. I’ll turn the floor back to Mr. Malkin for any final comments.

[Anthony Malkin, Chairman and CEO]

First of all, I want to say that the team has been executing at an extraordinary high level, continued great leasing, terrific execution on not only the redevelopment of our properties but the redevelopment of the Observatory. While all that’s up and running, just really pleased with what we’re doing there and a hats off to the whole team.

Great leasing spreads, net effective rent growth and momentum which we have seen continue into the third quarter. So we’re delivering on our goals and we look forward to the next time we report to you on our next quarterly earnings.

I very much want to give a last hats off to David. We’ve taken our hats off so many times, no one has a hat left. We look forward to seeing you all in the months ahead, conferences, NDRs, property tours calendared for the second half of the year. All the best, everybody. Thank you. Sorry for the long call.

[Operator]

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.