For investors seeking a reliable income stream, commercial property can offer very attractive opportunities; especially at a time when bonds and fixed income rates are at record lows.

In our article, Understanding the Commercial Property Market (Insight, Autumn 2017), we compared residential property yields with those of commercial property. The one year results favoured commercial property, with a yield of 6.3% in the year to 31 December 2016¹, in comparison with average residential property rental yields hitting new lows of just 3.1% in Australian capital cities over the same time frame². As further comparison, Australian shares currently offer an average yield of around 4.2%³.

So, while commercial property yields have moderated along with other investment returns as interest rates have fallen, the sector still remains a leader on yield. This isn’t simply a coincidence. In many ways, yield is the key to the commercial property market, driving both investor behaviour and asset prices.

Yields, prices and cap rates
In the residential property market, price often drives yields, rather than the other way around. Spurred on by sentiment or the hope of capital gains, residential property buyers have recently bid up the price of housing to exceptional levels, even while rents have remained relatively static.

As a result, residential rental yields have fallen dramatically, to levels well below those offered by other asset classes. Despite today’s low interest rate environment, many residential property investments now generate yields lower than the cost of borrowing, leaving investors with a potential loss, unless they can later sell at a high enough price to recover their costs (the strategy known as negative gearing).

In contrast, negative gearing is not a strategy pursued by commercial property investors. Not only do commercial property investors generally seek higher yields to cover their cost of debt, they typically value properties based on the rental income they can generate — similar to valuing a business on a multiple of profit.

A key concept here is the capitalisation rate or cap rate. Calculated by dividing a property’s net rental income by its value, cap rates are widely used to assess and compare potential commercial property investments. As a result, the value of a property often depends on the yield that investors are willing to accept.

Let’s look at an example to see how it works:

Imagine an investor owns a building valued at $10 million which generates a net income of $700,000 per year.

As a result, the building’s cap rate is: $700,000 ÷ $10,000,000 = 7%.

Now suppose that the same investor has the opportunity to buy a second building, which generates a net income of $1 million a year. How much should they be willing to pay for it?

Assuming they want to achieve the same 7% cap rate as their first investment, they would value the new building at:
$1,000,000 ÷ 7% = $14.28m.

But if they were willing to receive a cap rate of only 5%, they would be willing to pay more – up to
$20 million ($1,000,000 ÷ 5%).

That’s important, because investors don’t make decisions about yields in isolation. Instead, they are influenced by a range of factors, particularly changes in interest rate settings and the yield offered by other investments, especially bonds. Which is why changes in interest rates and bond yields can impact commercial property prices so strongly.