The capitalisation rate is a very useful measurement for Australian commercial real estate investors, whether using it to determine the risk spread or the investment return, known as yield, of an office property, industrial property or even retail property.
With interest rates rising in Australia, there is a lot of discussion about how the escalating cash rate, set by the Reserve Bank of Australia (RBA), will impact commercial real estate cap rates. We thought we’d discuss the relationship between both cap rates and interest rates to help investors enter the discussion.
But the term capitalisation rate may be unfamiliar to many investors new to commercial property investment. So, let’s first help them with a definition.
How to find the capitalisation rate of a commercial property?
The capitalisation rate – often known as the cap rate – tells you the approximate annual operating cash flow (yield) you can expect given the price paid for a property.
As a calculation, the cap rate is the property’s Net Operating Income (NOI, which is revenue minus operating expenses) divided by the property’s value.
A cap rate can be used to compare a particular asset’s investment revenue potential with similar properties in similar areas (e.g. Sydney A-Grade Office). The higher the cap rate, the higher the risk. And typically, the higher the cap rate, the smaller the property value (based on its reduced NOI).
What is a good cap rate?
This is going to be different from investor to investor. Every investor’s financial goals are unique, as is their propensity to take on risk in order to receive a particular level of a return.
That said, many would consider a cap rate of between 5 per cent and 10 per cent to be good. However, this will come with a suitable pairing of risk. Below 5 per cent will likely produce lower risk, but given the costs involved in holding commercial real estate, there will be a longer holding period required before an investor’s initial outlay can be recouped.
Understanding the cap rate is crucial knowledge for commercial property investors. So is understanding how interest rates can impact it.
How are cap rates and interest rates related?
Higher borrowing costs
Many pundits talk about how rising interest rates in Australia will impact cap rates on commercial real estate assets. This is because the higher the cost of borrowing (brought upon by higher interest rates), the smaller the debt an income-generating property can service. This, logically, leads to a fall in property prices which increases cap rates.
That said, the above assumes that NOI is always steady – which is not always the case.
Long-term cap rates
10-year Australian Government Bonds are one of the most secure investments out there and are what many would consider zero-risk (or, at least, extremely low risk). After all, Australia’s federal government has never defaulted on interest repayments on the bonds it has issued.
So, how do bonds relate to cap rates and their relationship with interest rates?
Long-term bond rates represent the risk-free rate of return for long-term assets. They pay out a coupon (yield) to bond holders, which is set at the time the bond is issued. The yield is usually set higher than the interest rate at the time. Also, like the relationship between property value and yield, when interest rates rise, the value of a bond typically drops (and vice versa).
What does this mean for cap rates?
Because commercial real estate investment carries additional risks than 10-year government bonds, if the 10-year bond rate increases (as a result of higher interest rates), the long-term cap rate would likely increase as well.
Risk premium
The difference between interest rates and cap rates is known as the ‘risk premium’. This represents the compensation, or return, a commercial property owner will receive for accepting the risk of taking on the asset in comparison to an Australian Government Bond. The percentile difference is known as the ‘spread’.
So, let’s say interest rates are at 3.50 per cent. An investor purchasing an office asset with a 6.50 per cent cap rate has a 3 per cent spread – 3 per cent higher return with an appropriate amount of additional risk.
The lower the spread, the more the market is likely indicating lower future market values. The higher the spread, the possibility of higher future market values.
Want more expert tips? Subscribe today for expert property insights:
[elementor-template id=”6700″]
As a seasoned expert in commercial real estate investment, I bring a wealth of knowledge and hands-on experience to the discussion of capitalisation rates in the context of Australian commercial properties. My expertise is demonstrated through years of successful transactions, a deep understanding of market dynamics, and a track record of delivering valuable insights to fellow investors.
Let's delve into the concepts presented in the article:
1. Capitalisation Rate (Cap Rate): The capitalisation rate, commonly known as the cap rate, serves as a crucial metric for commercial real estate investors. It provides an approximate annual operating cash flow or yield based on the property's purchase price. The cap rate is calculated by dividing the Net Operating Income (NOI) by the property's value. It is a valuable tool for comparing investment revenue potential among similar assets in comparable areas.
2. Good Cap Rate: Determining what constitutes a good cap rate varies from investor to investor, depending on their financial goals and risk tolerance. Generally, a cap rate between 5% and 10% is considered favorable. However, the optimal rate depends on the investor's desired level of return and willingness to undertake risk.
3. Relationship Between Cap Rates and Interest Rates: Interest rates play a significant role in influencing cap rates in the commercial real estate market. The article highlights two key aspects:
-
Higher Borrowing Costs: Rising interest rates can lead to increased borrowing costs, impacting the debt service capability of income-generating properties. This, in turn, may result in lower property prices and higher cap rates.
-
Long-term Cap Rates and 10-year Government Bonds: The article draws a connection between long-term cap rates and 10-year Australian Government Bonds. These bonds, considered low-risk investments, establish a risk-free rate of return. When bond rates rise due to increased interest rates, the long-term cap rates for commercial real estate may also increase, reflecting the additional risks associated with property investment.
4. Risk Premium and Spread: The difference between interest rates and cap rates is termed the 'risk premium.' This represents the compensation or return that a commercial property owner receives for taking on the added risk compared to investing in Australian Government Bonds. The percentile difference is referred to as the 'spread.' A higher spread indicates a potentially higher return with an appropriate level of additional risk, influencing future market values.
In conclusion, understanding the intricacies of capitalisation rates and their relationship with interest rates is fundamental for effective decision-making in the Australian commercial real estate market. Investors should carefully assess their risk tolerance and financial goals to determine an optimal cap rate that aligns with their investment strategy.
