Interest Rates & Commercial Property Yields

Commercial property cap rates track Australian government 10-year bond yields over time, though never in lockstep. The RBA cash rate, the 10-year bond yield and commercial cap rates sit as three points on the same curve, and knowing how interest rates feed through to commercial property yields gives a buyer a structural way to read the cycle.

Cap rates are not simply a function of interest rates. They price the market's view of property risk against the risk-free return, the depth of capital chasing property, and each sector's income growth outlook. Rates are one input.

The Three Rates That Matter

The RBA cash rate

The Reserve Bank of Australia's official cash rate is the policy rate its board sets. It anchors short-dated rates across the economy: the bank bill swap rate (BBSW), the prime lending rate and most variable-rate commercial loans.

10-year Australian government bond yield

This is the market-set yield on long-dated government bonds, and it reflects expected average future short rates plus a term premium. Cap rates get compared to the 10-year bond yield because both price a long-dated income stream.

Commercial property cap rates

The market multiple applied to commercial property net operating income to derive value, set by transaction evidence in each asset class. The gap between cap rates and bond yields is the property risk premium: what the market demands for taking property risk over government risk.

1 The Property Risk Premium

Cap rates typically sit 200 to 400 basis points above the 10-year bond yield. That spread, the property risk premium, varies by asset class:

• Long-WALE national-covenant single-tenant. The tightest spread, often 100 to 200 basis points above bonds, because a strong covenant delivers bond-like income.
• Industrial and core retail. 200 to 300 basis points: real-economy assets with growth optionality.
• Office. 250 to 400 basis points, on higher cyclical exposure and capex intensity.
• Specialist and complex assets. 300 to 500+ basis points, reflecting operating complexity and a limited buyer pool.

2 Rising Rates

When rates rise, three things happen to commercial property.

Bond yields rise

Higher cash rate expectations push 10-year bond yields up. The denominator in the property risk premium shifts upward.

Cap rates widen (with lag)

Repricing of cap rates lags the bond move by 6 to 18 months. Deals already in train complete at the old cap rates while new deals clear at the new ones, so there is a window where valuations are recalibrating but transaction evidence is thin.

Lender ICR tests tighten

Higher rates lift the buyer's interest cost, so the ICR test (interest cover ratio) is harder to satisfy at the same LVR. Lenders respond by cutting LVR or demanding bigger buffers.

Net effect on values

A 100 basis point cap rate widening on a 6% cap rate asset cuts value by roughly 17%. Real transactions show smaller falls because rent growth offsets some of it, but the direction is not in doubt.

3 Falling Rates

When rates fall, the dynamics reverse.

Bond yields fall

Lower cash rate expectations push 10-year bond yields down.

Cap rates compress (with lag)

The same 6 to 18 month lag applies. Deals in train complete at old cap rates, new deals clear at tighter ones, and the transition window rewards buyers who move before the market reprices.

Lender ICR tests loosen

Lower rates cut the buyer's interest cost, so a higher LVR or a larger loan clears at the same income level.

Capital flows

With bond yields lower, commercial property's yield premium looks relatively more attractive. Institutional capital and overseas investors lift their allocations, and the buyer pool deepens.

4 The Asymmetry of the Cycle

The two directions are not symmetric. Falling rates compress cap rates over a longer period, with the market re-pricing gradually as new transactions accumulate. Rising rates can widen cap rates abruptly: transaction volume slows, capital withdraws, and the market resets at the new bond level.

The 2020-2022 period shows both directions. Bond yields fell from 1% to 0.5% during 2020 and cap rates compressed gradually over 2020 and 2021; bond yields then rose to 4%+ during 2022 and cap rates widened more sharply over 2022 and 2023.

5 Sector Differences

Not all commercial property reacts to rates the same way. Three factors drive the difference.

Lease structure

Long-WALE assets with CPI plus minimum rent reviews benefit from inflation, so cap rate widening is partly offset by income growth. Fixed-rate reviews give less inflation protection.

Capex intensity

Older office with heavy capex needs is more rate-sensitive than modern industrial; the higher financing costs compound its operational drag.

Income growth outlook

Asset classes with structural growth, such as industrial and certain medical, command tighter cap rates than mature or cyclical classes, and their response to rate moves reflects that growth offset.

6 Buyer-Side Framework

Underwrite at conservative rates

The senior lender tests ICR at a buffer rate, typically 1.5% to 2.0% above current. Underwrite the same way: model the deal at the buffer rate and confirm ICR still clears.

Model the refinance

Commercial loans typically refinance every 3 to 5 years, and the rate you refinance at is unknown. Your protection is keeping LVR conservative enough that the deal still works at materially higher rates.

Watch the rate trajectory, not the point

A rate environment forecast to fall over the hold period favours higher LVR and tighter cap rate purchases. One expected to rise favours lower LVR and discount-to-replacement-cost purchases.

Price the exit cap rate

IRR calculations should use a realistic exit cap rate at the assumed hold-end. Buy at a 5% cap rate and exit at a 6% cap rate and the IRR comes in below what the entry yield suggests, even with strong income growth.

7 Where We Are Now

Rate conditions move continuously and the framework moves with them. Benchmark any specific call on current cap rate trajectories against the published series: Knight Frank Australian Capital Markets, JLL Real Estate Intelligence, Colliers Research and Savills World Research.

Frequently Asked Questions

Should I wait for rates to fall before buying?

Timing rate cycles is hard. The disciplined approach is to find a brief-fit asset at a fair price for current conditions, with leverage sized so the deal works at higher rates. Asset-specific value usually beats macro timing.

Do all asset classes move with rates equally?

No. Long-WALE assets with strong covenants move closer to bond yields, while multi-tenant cyclical assets vary more independently. Use sector-specific evidence.

Does the RBA cash rate matter more than the bond yield?

For variable-rate commercial loans, the cash rate is the more direct input. For valuation, the 10-year bond yield matters more because it prices long-dated income streams. Both count.

What if rates and inflation rise together?

Lease structures with CPI plus minimum reviews give partial inflation protection; fixed-rate review structures do not. Checking the lease structure matters more in an inflationary environment.