Interest and capitalisation rates explained

Since May 2022, the Reserve Bank of Australia (RBA) have increased the cash rate at ten consecutive meetings in a row.

While changes to the cash rate and subsequently interest rates are commonly discussed in the media, capitalisation rates are a far less talked about.

Here we explain the difference between cash rates, interest rates and capitalisation rates, how each interrelate and how changes to these rates impact commercial property investors.

What’s the cash rate and how does it impact interest rates?

According to the RBA, the cash rate is the (near) risk-free benchmark rate (RFR) for the Australian dollar and is also known as the AUD (or Australian Dollar) Overnight Index Average (AONIA) in financial markets.

From February to December the RBA meet monthly to discuss monetary policy and to determine the official cash rate, or the interest rate that banks must pay to borrow funds from other banks overnight.

The RBA make changes to the cash rate in order to influence economic activity, such as by encouraging spending (lowering the cash rate) or to curb inflation (increasing the cash rate) such as what we are seeing in the markets currently. When changes to the cash rate occur, this usually trickles down and is passed on by financial institutions through their variable and fixed mortgage interest rates as well as to interest that can be earned on savings accounts, in cash management trusts and on interest for personal loans.

The interest rates set by your financial institution (or lender) determines how much you will be charged for borrowing money from them.

What are capitalisation rates and how are they calculated?

Capitalisation rates, or cap rates as they are commonly known, refer to the expected annual cash flow (yield) you can earn from an investment property given the price you paid for it.

To determine the cap rate for your commercial investment property you first must calculate the Net Operating Income (NOI). A simple formula to calculate your NOI is:
Net revenue minus operating expenses divided by the property’s current market value.

Operating expenses incurred by commercial property owners in this equation include things like repairs and maintenance costs, land tax, council rates, water rates, security and cleaning costs, insurance and property management fees. However, the NOI calculated excludes principal and interest payments on the commercial loan, tax, depreciation and amortisation and therefore is the figure that property valuers often refer to as the true net figure, rather than the gross net figure, of a property.

Generally, a cap rate will be expressed as a percentage.

Why are cap rates important for commercial property owners?

There are a couple of reasons why knowing the cap rate for your commercial property can be of benefit.

Firstly, cap rates can be used if you are looking to purchase a new commercial property and want to compare a particular asset’s investment revenue potential with another similar property you might be completing due diligence on.

Secondly, knowing the cap rate can help you to determine the level of risk involved in purchasing and holding a commercial property. In general, the higher the cap rate, the higher the level of risk and return.

For commercial property, average cap rates range from 4 to 10 per cent. A commercial property with a cap rate more than 7 per cent may be perceived to be of higher risk than a property with a cap rate below 5 per cent.

It’s important to note that cap rates are not the only factor commercial investors should consider when choosing to purchase or continue holding a property. Other factors such as location, demand for the type of asset and external market influences should also be taken into account.

How do interest rate changes impact cap rates?

While principal and interest payments are excluded when calculating NOI, changes to the cash rate and subsequent interest rate rises can still have an impact on capitalisation rates.

This occurs for two reasons. Firstly, any change in interest rate signals a rise or fall in inflation. When inflation is rising, the operational expenses involved in holding a commercial property also have the tendency to go up.

Secondly, any additional funds required to cover increasing interest rate repayments can reduce the value of future income and tighten borrowing conditions. Therefore, higher interest rates can reduce the value of commercial properties and lead to cap rates increasing as buying will come with additional risk during these times.

How can Commercial Collective assist? 

If you’re considering purchasing any property Commercial Collective has on the market, we can provide a detailed financial summary of information about the property.

Our summary provides all the information required on gross rent, net income and outgoing operational expenses to enable you to calculate the cap rate for the property you are interested in.

Commercial Collective can also build protections into commercial property leases to cover commercial property owners for rises in inflation to help reduce their risk.

You can browse our latest commercial property offerings today.