Commercial Property. Explained. | A CBRE Private Wealth series

By Ingrid Filmer
Senior Managing Director, Capital Markets – Private Wealth, CBRE

One of the first things that confuses residential investors when they move into commercial property is the language around yield and cap rate.

You will hear someone say, “That property traded on a 5% cap rate,’ or “The yield was 5.5%,’ and it can sound as though everyone else understands exactly what that means.

The concept is actually quite simple.

A capitalisation rate, usually shortened to cap rate, is the rate used to convert the net income from a property into a value.

If a property produces $100,000 a year in net operating income and the market says that type of property should trade on a 5% cap rate, the simple capitalisation calculation gives you a value of $2 million.

$100,000 divided by 5% = $2,000,000.

That is the basic idea.

But there are three things I think new investors need to understand before they start comparing properties using cap rates.

First, the rate and the price move in opposite directions. Second, a cap rate is not the same thing as the return you personally make on your money. Third, a 5% cap rate on a directly owned property cannot be compared directly with a 7% distribution yield from a REIT, unit trust or property syndicate.

The higher the cap rate, the lower the price
This is the part that catches people all the time.

If the income stays the same, a higher cap rate produces a lower property value. A lower cap rate produces a higher property value.

It feels backwards until you see the maths.

Take a property producing $100,000 of net income:

Cap rate	Value from $100,000 net income
4.5%	$2.22m
5.0%	$2.00m
5.5%	$1.82m
6.0%	$1.67m

Nothing about the rent changed. The only thing that changed was the rate investors were prepared to apply to that income.

This is why you will hear people say yields have “compressed’ when prices rise. If investors are prepared to accept a lower income return for the same rent, they will pay more for the property.

If yields “soften’ or expand, the same income capitalises to a lower value.

That inverse relationship is one of the most important concepts to understand in commercial property.

So what is the difference between cap rate and yield?
In everyday commercial property conversations, the words are often used almost interchangeably, but technically there is a distinction.

A yield is the return that results when you divide an income figure by a property price or value.

A cap rate is the rate you apply to an income figure to derive a value.

In other words, yield can be an output and cap rate can be an input.

In practice, the distinction often becomes blurred because both are expressed as percentages and both relate income to value.

There are also different kinds of yield. You may hear passing yield, initial yield, market yield, effective yield or reversionary yield. They can use different income assumptions.

That is why, whenever someone tells me a property is “on a 5% yield’, my next question is: 5% based on what income?

Is it the rent the tenant is paying today? Is it adjusted to market rent? Have incentives or vacancies been allowed for? Is it net of the relevant operating expenses?

The percentage on its own is not enough.

Cap rate is a property measure, not your personal return
This is another area where investors can become confused.

A 5% cap rate does not mean you personally make 5% on the money you invested.

The cap rate is based on the property’s net operating income relative to its value. It is generally measured before your financing costs, principal repayments, income tax and depreciation.

Depreciation is particularly important to separate from the cap rate discussion.

Depreciation can be a valuable tax deduction for an owner of commercial property, depending on the property and the investor’s circumstances. But depreciation is not an operating cash expense of the property. It therefore does not reduce the property’s cap rate in the same way that an operating expense does.

Your personal return begins after you work through how you funded the purchase, what interest you pay, what capital expenditure you incur, what tax deductions are available to you, and what happens to both the rent and the property value over time.

A worked example: 5% direct property versus a 7% REIT distribution
This is where comparing headline percentages can become misleading.

Imagine you buy a $2 million commercial property producing $100,000 a year in net operating income.

That is a 5% cap rate.

Now assume, purely for illustration, that you borrow 50% of the purchase price. You have a $1 million loan and $1 million of equity before acquisition costs.

If the interest rate on that loan is 6%, the annual interest cost is $60,000.

Your $100,000 of property income is therefore reduced to $40,000 of cashflow before tax, principal repayments, capital expenditure and other investor-specific costs.

On your $1 million of equity, that is 4% cash-on-equity before those other items.

If you borrowed 60% instead, the loan would be $1.2 million. At 6% interest, interest would be $72,000. That leaves $28,000 from the $100,000 net property income before tax, principal repayments and capital expenditure.

On $800,000 of equity, that is 3.5% cash-on-equity before acquisition costs and the other items.

Depreciation may then improve your after-tax outcome because it can reduce taxable income without being a cash outgoing. Capital growth and rental growth may also add to your total return over time.

Now compare that with a REIT or property fund showing a 7% distribution yield.

A 7% distribution yield is generally an investor-level income measure based on distributions paid relative to the unit or security price. The vehicle itself may already have paid property operating costs, management fees and interest on its own borrowings before making those distributions.

So a 7% distribution from a REIT and a 5% cap rate on a property are not two versions of the same return.

You cannot look at 7% versus 5% and conclude that one investment is automatically better.

With direct property you may have your own leverage, depreciation benefits, control over leasing and capital works, and exposure to changes in the underlying property value. With a REIT or syndicate, you may have professional management, diversification and easier liquidity, but you are investing after the vehicle’s own costs and gearing structure.

Both can produce income and capital returns. They simply report those returns differently.

Why yield is useful for comparing property prices
One of the reasons yield is so important in commercial property is that it gives you a much better framework for comparing income-producing assets than simply looking at the sale price next door.

If the shop next door sold for $1 million, that does not mean your shop is worth $1 million.

What rent was the neighbouring property producing? Who was the tenant? How long was the lease? Was the rent above or below market? Was the building newer? Did it have more land? Was there redevelopment potential? Were major capital works coming?

In commercial property, the income and the quality of that income are fundamental to value.

That is why market yield evidence can be so useful. CBRE and other commercial property research teams publish market data and reports across different sectors and locations. Those reports can help investors understand the range of yields being achieved for different asset classes, markets and property characteristics.

But a market yield range is still only a guide. You then need to adjust your thinking for the actual property in front of you.

What changes the cap rate or yield investors will pay?
The rate is not determined by one thing.

Tenant covenant matters. Investors will often accept a different rate for a strong national or government-backed tenant than for a small private business, all else being equal.

Lease term matters. A long secure lease may attract stronger pricing than a property where the income is about to expire.

Rent level matters. If the property is significantly over-rented, the current income may not be sustainable when the lease resets or the tenant leaves. That can affect the rate investors are prepared to pay. If the property is under-rented, an upcoming review or expiry may create upside.

Land size and underlying land value matter. A property may have strategic value beyond the current rent because of its land, zoning or future redevelopment potential.

Location matters. So do access, visibility, parking, surrounding development and the depth of the future tenant market.

Capital expenditure matters. If a roof, air-conditioning system, lift or major piece of plant is close to the end of its life, a buyer may price that future cost into the deal.

The structure of the lease matters. So do rent reviews, options, outgoings recoverability and incentives.

This is why two apparently similar properties can trade on different yields.

Do not buy the percentage
When I look at a commercial property, I am not trying to buy a 5% yield or a 6% yield.

I am trying to understand what income I am buying, how secure that income is, what could make it grow, what could cause it to fall, what capital I may need to spend and what the property itself may be worth in the future.

The cap rate or yield is a way of expressing all of that risk, security and opportunity in one number.

It is incredibly useful, but it is not the analysis by itself.

So when you see a commercial property advertised on a particular yield, remember four things.

Ask what income the percentage is based on.

Remember that a lower yield generally means a higher price for the same income, and a higher yield means a lower price.

Do not confuse the property’s cap rate with the return you personally make after finance, tax, depreciation and capital expenditure.

And never compare a direct-property cap rate with a REIT, unit trust or syndicate distribution yield as though they are like-for-like numbers.

Understand what sits underneath the percentage.

That is where the real investment decision begins.

Important distinction
A direct-property cap rate is a property-level income-to-value measure. A REIT or fund distribution yield is an investor-level distribution-to-price measure after the vehicle has incurred its own costs and financing. Neither percentage, by itself, tells you total return.

Commercial property does not need to feel too hard. Follow the series and let’s demystify it together.