What Exactly is a Cap Rate?

It doesn’t take long once you step into the world of real estate before you hear the term “Cap Rate.” In fact, rarely does a day in my life go by without hearing the phrase: “What’s the Cap?” For some, this question results in confusion. For others, it’s a rush of adrenaline as they await the answer to whether their new investment has been found. Let’s take a few moments to break down the Cap and de-mystify this most common of commercial real estate concepts.

What is a Cap Rate?

Cap Rate is short for “income capitalization rate” and is commonly used for analyzing income-producing properties. In its simplest definition, the Cap Rate (R), expresses the relationship between the property’s Net Operating Income (NOI) and the Value (V) of the property.

To take it one step further, because the Cap Rate is a ratio of three variables, if you know two of the variables you can calculate the third one. The relationship of these three variables is inverse, so if the Cap Rate goes up, the value goes down; if the Cap Rate goes down, the value goes up.

The 3 Formulas:

NOI (I) ÷ Cap Rate (R) = Sales Price (V)
$80,000 ÷ 8% = $1,000,000

NOI (I) ÷ Sales Price (V) = Cap Rate (R)
$80,000 ÷ $1,000,000 = 8%

Sales Price (V) x Cap Rate (R) = NOI (I)
$1,000,000 x 8% = $80,000

These formulas are commonly portrayed in this graphic:

How Do Cap Rates Affect Buyers and Sellers?

In its simplest interpretation, Buyers tend to look for higher Cap Rates when purchasing properties as higher Caps equate to lower purchase prices and higher returns. Conversely, sellers want to sell at lower Cap Rates which translate to a higher sale price for the property. Remember, it’s an inverse relationship between the Cap Rate and the value!

What Dictates Cap Rates in the Market?

There are several factors that can affect the Cap Rate for a property, here are a few:

Interest Rates – When rates are higher, banks lend less money to remain within their debt-to-income requirements. Lower lending ability decreases demand in the market leading to lower prices and higher Cap Rates.

Risk – The more risk associated with an investment the higher the Cap Rate should be to compensate an investor for that risk. Alternately, lower risk investments will attract more investor demand and have lower Cap Rates.

Condition – A property’s physical condition as well as the investment’s business fundamentals affect the Cap Rate. If a property has a high vacancy rate or operational challenges or functional obsolescence or any one of countless factors that can affect an actual or potential Net Operating Income, it will certainly be reflected in the value of the property and the return an investor can expect, also known as the Cap Rate.

What Doesn’t the Cap Rate Tell Us?

The Cap Rate is a great tool to give us a quick evaluation at a specific point in time. It doesn’t tell us the whole story though and seasoned investors know that it’s just a starting point in an investment analysis. So, what does the Cap Rate leave out of the analysis of an investment property?

Leverage – Cap Rate assumes a cash purchase and does not take into consideration any loan details which can significantly affect the potential upside and downside of an investment.

Trends – Cap Rate is calculated over a one-year span, usually the previous year’s NOI. It does not consider changes in income over time, vacancy fluctuations, rental concessions, etc. Just because the Cap may look great now, what does the trend over the last few years look like?

Appreciation – Not only is the Cap limited when looking back over several years, it also doesn’t account for any increases in the asset value due to increases in the income, lease rates and market/economic conditions in the future. For example, multi-family assets in the Phoenix area and many similar fast-growing markets around the country have been trading for very low Cap Rates with the assumption that the demand for apartments will continue pushing the lease rates higher in turn increasing the value of these properties. Over the last several years these assumptions have proven right, and investors have been rewarded for taking the risks.

Tax Benefits – Every investor tax strategy is unique but taking into account asset depreciation, cost segregation, 1031 exchanges, opportunity zones and other tax related benefits can impact the fundamentals of a real estate investment. This is why having a CPA and legal team well versed in commercial real estate investing is so important.

Now that you know the basics of capitalization rates, it’s time to learn more about making money in the real estate industry!

As always, if you have questions about your business and investment goals, I am happy to meet and help you build a strategy for your long-term success.

Top Ten Projects in the Phoenix Pipeline

The market for development may have slowed from its peak level of activity a couple years ago, but there are still many significant projects under construction across the valley. These projects will impact the skyline, job creation and the future economic foundation for many years to come. Here is a list of some of my favorite projects that will change the Arizona commercial real estate and economic landscape:

Taiwan Semiconductor Manufacturing Company

It would seem wrong not to begin with this project which I have written about before. The largest foreign capital investment in Arizona history is now in its third year of construction and is expected to have its first fab completed in 2025. TSMC has already hired more than 2,000 employees and is expected to hire at least another 2,500 at full buildout. This is now a $40 billion project across two semiconductor fabrication facilities that have already impacted the real estate and economic dynamics in Phoenix. Simply put, this is a BIG deal!

Intel Expansion

As if TSCM isn’t enough, the valley is expanding its presence in the semiconductor industry with Intel’s construction of two new fabs totaling $20 billion in Chandler. These new fabs are expected to generate 3,000 high paying tech jobs directly and another 15,000 indirect jobs over the next 3 to 5 years as they approach buildout.

Nestle

Who doesn’t love Nestle! Did you know that Nestle is building a 630,000 SF manufacturing plant in the Glendale area? Situated on 150 acres, this $675 million development will produce creamers for Coffee Mate, Coffee Mate Natural Bliss and Starbucks brands plus the capacity to expand with additional beverages in the future. The project is expected to be open in the next few months and employ about 350 full time people.

VAI Resort and Mattel Adventure Park

This $1 billion project is also in Glendale and its first phase consisting of a music-themed hotel, amphitheater, concert venue and indoor theme park is expected to be open by the end of 2024. Concerts should start this year and reach 100 shows per year. The full development will consist of four hotel towers, a party island, a beach-like water feature, luxury retail, dining and entertainment with an economic impact to Glendale of $32 million annually or about $800 million over the next 25 years. Way to go Glendale!

Mall Madness

Three mall re-development projects are under way in the Valley – Metrocenter Mall, Paradise Valley Mall and Fiesta Mall. At one time these were all major destination shopping sites but changing consumer habits and aging infrastructure took their toll on the retail viability of these sites. Expect these new developments to include multi-family units, hotel, retail, dining, class A office space in addition to a fair mixture of community and park space mixed in. The next generation of these once popular malls is looking very bright once again.

South Pier

For those of us who have lived here for twenty years plus we have witnessed first-hand the birth and growth of Tempe Town Lake. What amazing progress and beauty has transpired in this part of Tempe not to mention the billions of dollars invested in this prime area. South Pier is another multi-billion-dollar project on 18 acres that will include office space, rentable luxury apartments, condominiums, senior housing, two luxury hotels and an entertainment district that will include restaurants, nightlife experiences, concert venues, fountain shows and a large Ferris wheel. This project is expected to take a decade or longer for completion, so be patient and enjoy the continued transformation of this important economic engine in Tempe.

Discovery Oasis

Phoenix City Council in late 2023 approved new ordinances paving the way for a new Mayo Clinic Discovery Oasis Biotech corridor on a 120-acre hub south of the 101 between 56th and 64th Street. I had the chance to see Mayo Clinic in action when my father received a kidney transplant in 2023, saving his life and in turn blessing all his friends and family who love him. I saw how one of the greatest medical institutions in the world functions and it is both awesome and inspiring to see what can happen when the best of intentions, investment and genius come together. This project will add 2,000 high-wage jobs to the valley, but the real impact is on the lives transformed for the thousands of patients that travel from around the world for this one-of-a-kind medical institution. The fact that it happens to be in this town we call home is something all of us should be proud of.

One Camelback

This project represents one of several office-to-residential conversions in Phoenix Metro. It’s considered to be the most high-profile of the projects because of its prime location on Camelback and because the project has had several challenges since breaking ground in 2020 underscoring how complex these conversions are and the risk that developers take to transition a struggling asset class like office to a healthier product like apartments. It may sound like a no-brainer but it is much more complicated and plenty risky for these developers. Still, because of the dwindling available land left in metro Phoenix to build on, you will find more of these types of projects trying to capitalize on conversions.

Data Center

Phoenix has the largest pipeline of new data center developments in the country. They may not be as exciting as South Pier or an adventure park, but their presence and impact on the Valley’s economy cannot be ignored. This new wave of data centers will cost billions of dollars, cover millions of square feet and will power some of the largest tech users in the world like Meta, Google, QTS Realty Trust and Vantage Data Centers. In fact, the Google project in Mesa will power the company’s tools like Search, Gmail, Maps, and the next generation of artificial intelligence innovation. So, can we agree that they are a little exciting??

Scottsdale Developments

Scottsdale has several large projects under way bringing new nighttime retail options to this already popular entertainment center. The Sidney is a $100 million project on 26 acres near 90th Street and the Loop 101 freeway that will include a new Reverb hotel by Hard Rock, Pickle and Social, The Rustic and Goodsurf. Speaking of Pickles, the new Riverwalk Development, located along the 101 between Talking Stick Way and Via de Ventura will be the home to Pure Pickleball, an 11-acre facility consisting of 40 indoor and outdoor pickleball courts and the future headquarters and training center for USA Pickleball, which is the governing body for the sport. Look for these projects to be open by the end of 2024.

There are dozens of projects under development Valley-wide, but these are some of the ones I am most looking forward to seeing in the coming months. I hope you are excited as I am to see our great city continue to grow, diversify, and build the foundation for our economic future!

If you have questions about your business and investment goals, I am happy to meet and answer any questions you have while we build a strategy for your success.

In Retail Leasing, Advantage is Back in the Landlord’s Court

The era of retail tenants ruling the leasing market appears to have passed, retail real estate brokers say. While retailers in certain product categories and in smaller markets may still be pursuing rent concessions when negotiating lease renewals, in much of the nation negotiating tactics have returned to the status quo.

In addition to the general improvement in leasing fundamentals, the lack of new retail development over the past few years has made existing space more valuable, says John Bemis, executive vice president and retail market lead for the Southeast with real estate services firm Jones Lang LaSalle. That has meant that retailers with access to good locations don’t want to lose them when their leases come up for renewal.

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