Commercial property cap rates and Australian government 10-year bond yields move together over time, though not in lockstep. The RBA cash rate, the 10-year bond yield, and commercial cap rates are three points on a related curve, and understanding how they relate gives buyers a structural framework for reading the cycle.
This article covers the relationship between rates and yields, why the relationship is not linear, what rising and falling rate environments do to commercial property valuation and lending, and the buyer-side framework for underwriting in different rate regimes.
Cap rates are not just a function of interest rates. They reflect the market's view of property risk relative to risk-free returns, the depth of capital chasing property, and the sector's specific income growth outlook. Rates are one input, not the only one.
The Three Rates That Matter
The RBA cash rate
The Reserve Bank of Australia's official cash rate is the policy rate set by the RBA Board. 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
The market-determined yield on long-dated government bonds. Reflects the market's expected average future short rates plus a term premium. Commercial cap rates are commonly compared to the 10-year bond yield because both are long-dated income-stream-pricing instruments.
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 spread between cap rates and bond yields is the "property risk premium" 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. This spread, the property risk premium, varies by asset class:
- Long-WALE national-covenant single-tenant. Tightest spread, often 100 to 200 basis points above bonds. Bond-like income from a strong covenant.
- Industrial and core retail. 200 to 300 basis points. Real-economy assets with growth optionality.
- Office. 250 to 400 basis points. Higher cyclical exposure and capex intensity.
- Specialist and complex assets. 300 to 500+ basis points. Reflects operating complexity and limited buyer pool.
2 Rising Rates
In a rising rate environment, 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 equation shifts upward.
Cap rates widen (with lag)
The market repricing of property cap rates lags the bond move by 6 to 18 months. Existing transactions complete at old cap rates; new transactions clear at the new cap rates. The lag creates a window where valuations are recalibrating but transaction evidence is thin.
Lender ICR tests tighten
Higher interest rates increase the buyer's interest cost. The ICR test (interest cover ratio) becomes harder to satisfy at the same LVR; lenders may reduce LVR or require higher buffers.
Net effect on values
Mathematically, a 100 basis point cap rate widening on a 6% cap rate asset reduces value by approximately 17%. Real-world transactions show smaller declines because of underlying rent growth, but the directional impact is clear.
3 Falling Rates
In a falling rate environment, 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. Existing transactions complete at old cap rates; new transactions clear at the new (tighter) cap rates. The transition window creates an opportunity for buyers acting before the market reprices.
Lender ICR tests loosen
Lower interest rates reduce the buyer's interest cost. Higher LVR or larger loan amounts become viable at the same income level.
Capital flows
Lower bond yields make commercial property's yield premium relatively more attractive. Institutional capital and overseas investors increase allocation, deepening the buyer pool.
4 The Asymmetry of the Cycle
Falling rates and rising rates have asymmetric effects:
- Falling rates compress cap rates over a longer period. Markets re-price 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 illustrates both directions: bond yields fell from 1% to 0.5% during 2020, cap rates compressed gradually over 2020 and 2021; bond yields rose to 4%+ during 2022, cap rates widened more sharply over 2022 and 2023.
5 Sector Differences
Not all commercial property reacts to rates the same way. Three principal factors:
Lease structure
Long-WALE assets with CPI plus minimum rent reviews benefit from inflation; cap rate widening is partly offset by income growth. Fixed-rate reviews provide less inflation protection.
Capex intensity
Older office with high capex needs is more rate-sensitive than modern industrial. Higher financing costs compound the operational drag.
Income growth outlook
Asset classes with structural growth (industrial, certain medical) command tighter cap rates than mature or cyclical asset classes. Their cap rate response to rate moves reflects the 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). The buyer should underwrite the same way: model the deal at a buffer rate and confirm that ICR still clears.
Model the refinance
Commercial loans typically refinance every 3 to 5 years. The refinance rate is unknown; the buyer's 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 that is forecast to fall over the hold period favours higher LVR and tighter cap rate purchases. A rate environment expected to rise favours lower LVR and discount-to-replacement-cost purchases.
Price the exit cap rate
Buyer's IRR calculations should use a realistic exit cap rate at the assumed hold-end. A purchase at a 5% cap rate that exits at a 6% cap rate produces lower IRR than the entry yield would suggest, even with strong income growth.
7 Where We Are Now
Current rate conditions move continuously; the buyer-side framework adjusts continuously. Specific calls about current cap rate trajectories should be benchmarked against current published series (Knight Frank Australian Capital Markets, JLL Real Estate Intelligence, Colliers Research, Savills World Research).
Frequently Asked Questions
Should I wait for rates to fall before buying?
Timing rate cycles is difficult. 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. Multi-tenant cyclical assets show more independent variation. Sector-specific evidence is the right reference.
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 property valuation, the 10-year bond yield is more relevant because it prices long-dated income streams. Both matter.
What if rates and inflation rise together?
Lease structures with CPI plus minimum reviews provide partial inflation protection. Fixed-rate review structures do not. The buyer-side review of lease structure becomes more important in inflationary environments.