Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 580

This property valuation metric needs a rethink

Capitalisation rates, commonly known as ‘cap rates’, are a fundamental metric in Australian property investing. When a commercial property is sold, two pieces of information will be widely reported. Firstly, the amount the property sold for and secondly, the cap rate. Often properties will be compared by their respective cap rates. Reports will often comment on the ‘implied cap rates’ of different property securities. However, this seemingly simple and ubiquitous measure can be far more complex to use when comparing different types of properties.

What is and isn’t in a cap rate

Whilst different market participants may mean different things when referring to a cap rate, the Property Council of Australia (PCA) defines a cap rate as a property’s net operating income (NOI) divided by its property value estimate. For example, if a property generates an annual NOI of $500,000 and is valued at $10 million, the cap rate would be 5%. A purchaser might assume that they would receive a cash flow yield of 5% plus any rental growth that may occur. This isn’t necessarily the case and ignores key considerations.

Capital Expenditure (Capex):

Commonly, properties require meaningful ongoing investment, which isn’t reflected in the NOI used to calculate cap rates. This investment is known as capex and comes in many different forms. It may be maintenance capex, which refers to significant replacements or additions to maintain the standard of an existing building. For office properties, this may include replacing lifts or air conditioning units, each of which may need a full replacement as often as every 15 years. For shopping centre properties, capex may include items such as escalators or shared facilities such as bathrooms. Maintenance capex is not directly reflected in increased rent and is commonly used to ‘maintain’ the relevance of an existing building. This amount is often referred to as a percentage of a building’s value. For example, if a building worth $100 million requires maintenance capex of $500,000 per year, it is common to say it requires 0.5% (or 50 basis points) of maintenance capex.

Leasing Incentives:

To attract and retain tenants, commercial property owners often provide ‘incentives’ to prospective and renewing tenants. These incentives can take many forms, but are commonly provided as rent-free periods, or contributions to a tenant’s fit-out. The size and form of incentives varies greatly between different property types. Incentives are commonly quoted as a percentage of the total rent to be paid over the tenant’s lease period. For example, if a tenant agrees to a 10-year lease for $100,000 per year, a 20% incentive would mean that $200,000 of benefits are provided to the tenant. Rent, less any incentives, is called ‘effective rent’ and in the above example effective rent would be $80,000 per year. Rent excluding incentives is called ‘face rent’. It is typically face rent that is used to calculate the NOI used in a cap rate.

Whilst not the subject of this article, it is worth noting that lease structures including term and rent reviews, as well as tenant quality are not considered in a cap rate. Buildings with longer leases, higher fixed rent increases and better tenant quality tend to attract lower cap rates than the alternative.

Now and then

In a past generation, institutional grade commercial property primarily consisted of office, retail and industrial property. Approximate leasing incentive and maintenance capex amounts across these subsectors 15 years ago can be seen in the table below:

Whilst there are some differences between the amount of cash flow leakage, the difference between property types is not enormous. Whilst industrial properties faced limited cash flow leakages, market rental growth had been extremely low for a long period. It may not have been perfect but comparing cap rates across these property types 15 years ago was not a terrible way to assess relative value.

Beyond any changes to leasing incentives and maintenance capex requirements, today’s listed property sector is much broader than it used to be. Alternative property types such as healthcare, social infrastructure, petrol stations and long WALE sale-and-leaseback properties are all part of the institutional investment landscape. Many of these property types are commonly leased in an owner favourable “triple-net” manner. A triple-net lease means a tenant is responsible for property taxes, building insurance and maintenance capital expenditure across the life of the lease.

A revised table approximating today’s leasing incentives and maintenance capex, including triple-net properties, can be seen below:

Mind the gap

It is clear when comparing the above tables, that the dispersion in incentives and capex has widened materially. In the case of an A grade office building, the gap between the building’s cap rate and its true cash flow yield is vast. The chart below demonstrates this visually for an office building with a 6% cap rate:

As can be seen, the cap rate in no way resembles the true cash flow of owning an office building, with more than half of the NOI received (used in calculating the cap rate) lost to capex and incentives.

Consider the four assets in the above table. In this example, each has a cap rate of 6%. The chart below shows the cash flow yield of each:

What to do?

Phoenix actively considers the factors affecting cash flows (among others) and explicitly forecasts longer term capex and incentives that property owners will be required to pay. It is these cashflows that determine value, not next year’s dividend or simply observing a cap rate.

A comparison of Dexus (DXS) and Charter Hall Social Infrastructure REIT (CQE) shows the importance of looking beyond headline cap rates and how this affects how Phoenix manages the portfolio.

DXS is predominantly an owner of high quality office properties across Australia. CQE is predominantly an owner of smaller properties leased to childcare providers on triple-net leases. CQE’s cash flow is boosted by a lack of incentives and capex. Childcare property rent is also an income stream heavily supported by the government, with support for funding of the sector a politically bipartisan issue. As at period end, DXS’ office cap rate implied by its share price was greater than 8.3%. CQE’s implied cap rate was more than 6.8%. If one were to merely compare cap rates, DXS would be the more attractive investment opportunity. It, however, faces significant cash outflows (in the form of capex and incentives) beyond what is measured in a cap rate. As such, Phoenix has held no position in DXS for some time and holds an overweight position in CQE.

The detail is important

Cap rates have the benefit of being simple. In the past they were also a reasonable way to compare property.

As incentives and capex levels have diverged between different properties, merely looking at cap rates has become a less appropriate way to consider the relative attractiveness of different properties.

By developing a more nuanced understanding of what's truly "in a cap rate", investors can make more informed decisions. Remember, the devil is always in the details, and in real estate investing, those details often lie beyond the simple cap rate calculation.

 

Stuart Cartledge is Managing Director of Phoenix Portfolios, a boutique investment manager partly owned by staff and partly owned by ASX-listed Cromwell Property Group. Cromwell Funds Management is a sponsor of Firstlinks. This article is not intended to provide investment or financial advice or to act as any sort of offer or disclosure document. It has been prepared without taking into account any investor’s objectives, financial situation or needs. Any potential investor should make their own independent enquiries, and talk to their professional advisers, before making investment decisions.

For more articles and papers from Cromwell, please click here.

 

RELATED ARTICLES

Markets are about to get a whole lot harder

Investing in car spaces? Park that idea

banner

Most viewed in recent weeks

Retirement is a risky business for most people

While encouraging people to draw down on their accumulated wealth in retirement might be good public policy, several million retirees disagree because they are purposefully conserving that capital. It’s time for a different approach.

The perfect portfolio for the next decade

This examines the performance of key asset classes and sub-sectors in 2024 and over longer timeframes, and the lessons that can be drawn for constructing an investment portfolio for the next decade.

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

The challenges with building a dividend portfolio

Getting regular, growing income from stocks is tougher with the dividend yield on the ASX nearing 25-year lows. Here are some conventional and not-so-conventional ideas for investors wanting to build a dividend portfolio.

How much do you need to retire?

Australians are used to hearing dire warnings that they don't have enough saved for a comfortable retirement. Yet most people need to save a lot less than you might think — as long as they meet an important condition.

Welcome to Firstlinks Edition 594 with weekend update

It’s well documented that many retirees draw down the minimum amount required and die with much of their super balances untouched. This explores the reasons why and some potential solutions to address the issue.

  • 16 January 2025

Latest Updates

Investment strategies

UniSuper’s boss flags a potential correction ahead

The CIO of Australia’s fourth largest super fund by assets, John Pearce, suggests the odds favour a flat year for markets, with the possibility of a correction of 10% or more. However, he’ll use any dip as a buying opportunity.

9 ways to fix Australia's housing crisis

Decades of policy failure have induced a fall in housing affordability. Unless painful changes are made, an underclass will emerge in a society that is supposed to boast the one of the world's highest standards of living.

Shares

Australia: why the chase for even higher dividend yields?

Australia boasts one of the world's highest dividend yielding sharemarkets, providing substantial benefits to investors and retirees. Despite this, individuals often stretch for even more yield, to their detriment.

Shares

MIGA – Make Income Great Again

The Australian sharemarket seems to be rewarding a number of unprofitable companies on the promise of future riches. Yet profits and cashflows still matter, as a recent case study of Domino's Pizza shows.

Shares

Mapping future US market returns

Exceptional returns from the US sharemarket over the past decade have driven by sales growth, margin expansion, rising valuations, and dividends. Predicting future returns requires careful consideration of these factors.

Shares

Read this before you go all in on US equities

US equities rule global markets, but history is littered with examples of markets that seemed invincible — until they weren’t. Diversification will be key for investor portfolios going forwards.

Property

What impact would scrapping stamp duty have on housing?

Increasing house prices pose challenges for housing affordability. This investigates the impact of stamp duty on the property market, and how removing the tax could help address several key issues.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.