Australian commercial property investors are facing a very different investment environment from the one that existed when interest rates were near historic lows.

As interest rates rise, borrowing becomes more expensive, bond yields become more competitive, and investors reassess how much they are willing to pay for property.

In this episode of The CEO Breakdown, John Saade examined the pressure facing Australian property markets, including commercial property and listed property trusts. He highlighted an important issue for investors: property does not exist in isolation. It competes with other investments for capital.

When government bonds, term deposits and other interest-bearing investments offer higher returns, commercial property needs to provide an attractive risk-adjusted return to justify its additional risks.

For investors, this makes understanding yields, financing costs, property valuations and cash flow more important than simply assuming property prices will continue rising.

Why Are Rising Interest Rates Important for Commercial Property?

Interest rates can affect commercial property in several ways.

The most immediate impact is usually the cost of borrowing.

An investor with a commercial property loan may face higher interest expenses when lending rates rise. If rental income remains unchanged, the property’s net cash flow can deteriorate.

At the same time, higher interest rates can change how investors value property.

A simplified example illustrates the issue.

Imagine a commercial property generates $500,000 in annual net income.

If an investor values the property using a 5% capitalisation rate:

$500,000 ÷ 5% = $10 million

If the required yield rises to 6%:

$500,000 ÷ 6% = $8.33 million

The property’s income has not changed, but its implied value has fallen because investors now require a higher return.

This is one reason rising interest rates can place downward pressure on commercial property valuations.

What Is a Commercial Property Yield?

A commercial property yield is broadly a measure of the income generated by a property relative to its value.

One commonly discussed measure is the capitalisation rate, or cap rate.

The simplified formula is:

Capitalisation Rate = Net Operating Income ÷ Property Value

For example, if a property generates $500,000 in net operating income and is worth $10 million:

$500,000 ÷ $10 million = 5%

The relationship works in both directions.

If the income stays constant while the required yield rises, the property’s implied value generally falls.

This is particularly relevant when interest rates and bond yields increase.

Why Do Bond Yields Matter to Property Investors?

Commercial property does not compete only with other properties.

It competes with alternative investments.

When interest rates were extremely low, investors had fewer opportunities to earn relatively attractive returns from lower-risk assets.

As bond yields rise, that changes.

Consider a simplified example:

• Government bond yield: 5.3%
• Commercial property yield: 5%
• Commercial property: requires management and carries vacancy, maintenance and market risks

An investor may question why they should accept additional property risks for a lower headline yield.

This does not mean commercial property automatically becomes a bad investment.

It means the required return may change.

Investors need to consider whether the additional income and potential capital growth justify the additional risks.

How Higher Borrowing Costs Affect Property Investors

Many commercial property investments involve debt.

When interest rates rise, the cost of servicing that debt can increase.

For example, consider a property with:

• $5 million debt
• Interest rate of 4%
• Annual interest expense of $200,000

If the interest rate increases to 6%:

• Annual interest expense becomes $300,000

That is an additional $100,000 per year in financing costs.

If rental income remains unchanged, the investor’s cash flow is reduced.

For highly leveraged investors, the impact can be considerably larger.

Higher rates can affect:

• Cash flow
• Debt servicing capacity
• Refinancing
• Investment returns
• Property valuations
• Equity requirements
• Acquisition decisions

This is why investors should understand their debt structure before focusing solely on property prices.

What Happens to Commercial Property Valuations?

Commercial property valuations are influenced by several factors, including:

• Rental income
• Lease terms
• Tenant quality
• Vacancy rates
• Location
• Property type
• Capital expenditure requirements
• Market yields
• Interest rates
• Investor demand

Rising interest rates can put upward pressure on required investment yields.

If yields rise faster than rental income, valuations can come under pressure.

For example, a property producing $1 million in annual net income would have an implied value of:

$20 million at a 5% yield

But at a 6% yield:

$16.67 million

That represents a substantial difference in valuation without any change in the property’s rental income.

This demonstrates why investors need to monitor both income and valuation assumptions.

Why Commercial Property Can Be Different From Residential Property

Residential property is often influenced by factors such as:

• Owner-occupier demand
• Household income
• Population growth
• School zones
• Lifestyle preferences
• Housing shortages
• Investor sentiment

Commercial property has a stronger focus on income and investment returns.

For commercial investors, questions can include:

What is the rental income?

How long is the lease?

Who is the tenant?

What happens when the lease expires?

What are the vacancy risks?

What are the operating costs?

What yield does the property provide?

This means rising interest rates can have a particularly direct impact on commercial property investment decisions.

What Happens When Commercial Property Yields Become Less Attractive?

Suppose an investor can earn a higher return from a relatively low-risk investment than they can from a commercial property.

The investor may decide to wait.

That can reduce demand for commercial property.

If enough investors make the same decision, sellers may need to accept lower prices to attract buyers.

This is one mechanism through which higher interest rates can contribute to property repricing.

It is not necessarily a sudden crash.

Instead, the market may experience:

• Longer selling periods
• Fewer transactions
• Wider negotiation between buyers and sellers
• Lower valuations
• Higher required yields
• Increased pressure on highly leveraged owners

How Do REITs Respond to Higher Interest Rates?

Real estate investment trusts, or REITs, provide another way to gain exposure to property.

Listed property trusts can be particularly sensitive to movements in interest rates and bond yields.

Higher rates can affect REITs through several channels.

Financing costs

REITs may carry significant amounts of debt. Higher borrowing costs can increase interest expenses.

Valuations

Property valuations can fall if market capitalisation rates rise.

Investor preferences

When bond yields increase, investors may reassess the relative attractiveness of property securities.

Distribution expectations

Higher financing costs or weaker property income can potentially affect distributions.

As a result, listed property securities can experience significant share-price movements even when the underlying physical properties have not changed overnight.

What About Commercial Property Vacancies?

Vacancy rates are another important consideration.

A commercial property with a strong tenant on a long-term lease can have a very different risk profile from an office building with significant vacant space.

Higher vacancies can create pressure through:

• Lower rental income
• Incentives required to attract tenants
• Higher leasing costs
• Additional capital expenditure
• Reduced property valuations

This is particularly relevant in commercial property markets where changes in workplace behaviour have affected office demand.

Investors therefore need to examine the actual lease and tenant profile rather than relying solely on broad property-market trends.

How Can Property Investors Assess Commercial Property in a High-Rate Environment?

Investors should consider the property’s fundamentals rather than relying on general expectations about property prices.

1. Calculate the actual yield

Understand the property’s net income rather than relying on gross rent.

2. Stress-test interest rates

Calculate what happens if borrowing costs rise further.

3. Review the lease

Consider lease length, rent reviews, renewal options and tenant quality.

4. Examine vacancy risk

A property generating strong income today may look very different if the tenant leaves.

5. Consider refinancing risk

A loan that appears manageable today may become more expensive when it needs to be refinanced.

6. Compare alternative investments

Consider whether the expected property return adequately compensates for the risks involved.

7. Assess the property’s long-term fundamentals

Look at location, infrastructure, tenant demand, demographics and future development.

Is Commercial Property Still Worth Considering?

There is no universal answer.

A higher interest-rate environment does not automatically make every commercial property unattractive.

Some properties may have:

• Strong tenants
• Long leases
• Regular rental increases
• Low vacancy risk
• Attractive locations
• Manageable debt
• Strong long-term demand

Other properties may have significant exposure to refinancing, vacancies or falling rents.

The key is understanding the specific investment.

A property’s price alone does not tell you whether it represents good value.

Why Cash Flow Matters More When Rates Rise

When interest rates are low, investors can sometimes tolerate weaker short-term yields because they expect capital growth.

Higher interest rates can change that calculation.

An investor carrying substantial debt needs to know whether rental income can comfortably cover:

• Interest
• Property management
• Repairs
• Insurance
• Council rates
• Land tax
• Capital expenditure
• Other operating expenses

A property that looks attractive based on its purchase price may produce a very different outcome after all costs are considered.

What Should Commercial Property Investors Watch?

Investors should monitor several indicators rather than focusing on interest rates alone.

Key indicators include:

• Cash rate
• Commercial lending rates
• Government bond yields
• Capitalisation rates
• Vacancy rates
• Rental growth
• Tenant demand
• Refinancing requirements
• Property valuations
• Net operating income

Changes in these indicators can help investors understand whether the fundamentals of a property are improving or deteriorating.

The Importance of Getting Professional Advice

Commercial property decisions can involve significant amounts of capital and complex tax and financing considerations.

The right structure can depend on factors such as:

• Ownership structure
• Tax position
• Financing
• Existing assets
• Business structure
• Investment objectives
• Long-term plans

An accountant can help investors understand the tax and financial implications of a transaction, while other qualified professionals may be needed for property, legal or financial advice.

Frequently Asked Questions About Commercial Property and Rising Interest Rates

How do rising interest rates affect commercial property?

Rising interest rates can increase borrowing costs, reduce investment cash flow and contribute to higher required property yields. These factors can place downward pressure on commercial property valuations.

Why do bond yields affect commercial property?

Investors compare potential property returns with alternative investments. When bond yields rise, commercial property may need to offer a higher return to compensate investors for additional risks such as vacancy, maintenance and financing.

What happens to commercial property values when yields rise?

If rental income remains unchanged and the required yield rises, the implied property value generally falls. The extent of the change depends on market conditions and the property’s specific characteristics.

Are REITs affected by higher interest rates?

REITs can be affected because higher rates may increase financing costs, influence property valuations and change investor demand for listed property securities.

Should investors avoid commercial property when interest rates are high?

Interest rates are only one factor. Investors should consider the property’s income, lease, tenant quality, vacancy risk, debt structure, valuation and long-term fundamentals.

How can investors protect commercial property cash flow?

Investors can assess their debt structure, maintain appropriate cash reserves, stress-test interest rates, review leases and monitor operating expenses and rental income.

Can falling commercial property values affect borrowing?

Yes. A decline in property value can reduce an investor’s equity and may affect lending or refinancing, depending on the lender’s requirements and loan structure.

Need Help With Your Property Investment Structure or Tax Position?

Rising interest rates can change the cash flow, valuation and tax considerations surrounding commercial property.

Latitude Accountants helps Australian business owners and investors understand their accounting, tax and business structures so they can make informed decisions based on their circumstances.

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Enquire with Latitude Accountants to discuss your accounting, tax or advisory needs.

Disclaimer

This article provides general information and commentary only and does not constitute financial, tax, property, investment or business advice. Commercial property investments involve risks, including changes in interest rates, property values, rental income, vacancies and financing costs. Speak with a qualified adviser about your own circumstances before making financial, property, investment or business decisions.