Real estate investment trust (REIT) Empire State Realty Trust (NYSE: ESRT) is an office landlord with a little bit of exposure to ground-level retail. Today, in the face of the coronavirus, investors might be wondering if that's a worthwhile focus. This is a fair question, but it misses the really big risk at this specific REIT. Here's the real elephant in the room when it comes to Empire State Realty Trust.
The opportunity ahead
The coronavirus has pushed employees out of the office environment and into work-from-home mode. Some industry watchers have suggested this will end up being a permanent shift. Maybe, but it's highly likely offices will remain very important to businesses. There are just too many benefits from bringing people together to share and create.
Assuming the work-from-home trend shifts back toward a more normal work-from-work trend, retail stores on the bottom floor of office buildings will likely pick up again, too. So, long term, Empire State Realty's big-picture business model probably isn't broken. That suggests there's turnaround appeal here, even after a massive stock rally in November on positive coronavirus vaccine news. In fact, the shares are still roughly 30% below their early-year highs.
However, that doesn't mean the REIT is a great buy for every investor. But to figure out if you should steer clear, you need to look a little deeper.
The real problem to care about
Assuming the coronavirus is a temporary, surmountable problem, why not buy Empire State Realty Trust? The answer is right in the name. This REIT is hyperfocused on just one region: New York City and its surrounding suburbs. That's not a small issue.
On the company's website, the property map isn't an image of the United States; it's a closeup of just a small region of New York and Connecticut -- not even the entire states. If the office market in this area is weak, Empire State Realty Trust has nothing to fall back on to prop up its results. That lack of diversification should worry more conservative investors.
But there's more to this diversification risk than just the region in which the REIT operates. Just six properties make up a massive 73% of its rent roll. If any one of those properties has a problem, Empire State Realty Trust could find itself in a world of hurt, which would flow quickly through to shareholders.
Note that in the face of the coronavirus, the REIT stopped paying dividends in the third quarter. That's an extreme outcome driven by an extreme event, and the dividend should return at some point soon. But once things get back to "normal," it wouldn't be a shock to see a more modest dividend reduction if just a single property experienced operational difficulties.
Which gets us to the elephant in the room: The company's flagship property, the Empire State Building, makes up a huge 33% of the rent roll (roughly 40% of the rent from the property, meanwhile, comes from the observation deck).
There's no question the Empire State Building is an iconic asset, but having a third of this REIT's top line tied to a single property is a level of concentration that should worry even aggressive investors. Imagine what would happen if even half the property became unrentable because of something like a fire or an industrial accident. Is that likely to happen? Probably not, but is it worth the risk that it could?
Spread your bets around
New York is a great city, but there are a lot of other great cities in the country, too. And while few buildings have the same name cache as the Empire State Building, it's not really all that special when you think about it as an office building. Most investors would probably be better off putting their money to work in a more diversified office REIT.
In the end, Empire State Realty Trust is really a fairly high-stakes bet on the New York City region. That might be right for some people, but most would be better served by a more diversified approach.