Australian REITs Explained: Why Cap Rates Matter More Than Buildings

The most common mistake in analysing REITs is treating them as property and forgetting that they are leveraged bond-like instruments. A building generating unchanged rent can lose 20% of its value because bond yields rose, and because the debt against it did not change, the entire loss lands on the equity. Every dramatic move in Australian listed property over the past three years is explained by that mechanism rather than by anything happening in the buildings.

How does the capitalisation rate actually work?

It is the yield an investor requires to own the asset, expressed as net income divided by value. If a building generates A$10 million of net rent and investors require a 5% return, it is worth A$200 million. If required returns rise to 6%, the same building is worth A$167 million — a 17% decline with no change to the tenant, the lease or the rent.

Required returns move with the risk-free rate. When government bond yields rise, every income-producing asset must offer more to remain competitive, so cap rates expand across the sector. This is why property values fell substantially through the 2022 to 2024 rate cycle despite occupancy and rents in most sectors holding up.

The corollary is that a REIT can report rising rental income and falling net tangible assets simultaneously, which confuses investors reasonably. The income statement reflects the building; the balance sheet reflects the discount rate. Both are correct and they are measuring different things.

Why is gearing the amplifier?

Because debt is a fixed claim. A REIT with A$1 billion of property and A$300 billion of debt has A$700 million of equity at 30% gearing. If the property falls 15% to A$850 million, the debt remains A$300 million and equity falls to A$550 million — a 21% decline in equity from a 15% decline in assets.

That mechanism explains why REIT share prices move so much more than property values. It also explains why gearing levels and debt covenants receive so much attention: a REIT approaching a loan-to-value covenant during a valuation decline may be forced to sell assets into a weak market or raise equity at a depressed price, both of which crystallise the loss permanently.

The defensive positioning is therefore lower gearing and longer debt maturity than the arithmetic strictly requires. A REIT with modest gearing and no near-term refinancing can wait out a valuation cycle; one with high gearing and maturities in eighteen months cannot, regardless of how good its buildings are.

What happened to office property?

It experienced a genuine structural shift rather than a cyclical one, and Australian office REITs have been repricing accordingly. Hybrid working reduced the space per employee that organisations require, and while attendance has recovered from pandemic lows, few employers have returned to pre-2020 space assumptions.

The effect has been sharply bifurcated. Premium, well-located, environmentally certified towers have retained tenants and rents, because organisations reducing total space have used the opportunity to upgrade quality. Secondary stock in less attractive locations has faced rising vacancy, higher incentives and falling effective rents.

Incentives are where the damage is hidden. Landlords maintain headline rents while offering rent-free periods and fit-out contributions that can represent a substantial share of the lease value, which preserves reported rental income and valuation while destroying actual cash returns. Effective rent rather than face rent is the number that matters, and it is disclosed inconsistently.

Why did industrial property outperform?

Because e-commerce structurally increased demand for warehouse space at the same time that urban industrial land was being rezoned for residential use. Rising demand meeting shrinking supply produced the strongest rental growth of any Australian property sector for most of the past decade.

The distribution economics are the driver. Online retail requires several times more warehouse space per dollar of sales than store-based retail, because inventory must be held, picked, packed and returned rather than displayed. Every shift in consumer behaviour toward online purchasing converts retail floorspace demand into logistics floorspace demand.

That advantage has now been partly capitalised into prices, and the sector’s next phase is different. Goodman’s pivot toward data centres reflects a judgement that the highest-value use of urban industrial land with power is no longer storing goods but housing compute — which is a rerating of the land rather than of the warehouse.

How should investors think about REITs?

As a distinct asset class with bond-like and equity-like characteristics, not as a proxy for owning property directly. REITs offer liquidity, diversification and professional management that direct property cannot, at the cost of daily price volatility that direct property conceals rather than avoids.

The distribution is the primary return for most holders, and its sustainability depends on funds from operations rather than statutory profit. Statutory earnings include revaluation movements that are non-cash and can swing enormously in both directions; funds from operations measures the cash the portfolio actually generates and is what supports the distribution.

For Australian investors specifically, REITs interact with the rest of the market in a way worth noting. Listed property is a large component of the ASX, superannuation funds hold both listed REITs and direct property, and the same interest rate move that reprices bank earnings reprices property valuations in the opposite direction. Diversification within a domestic portfolio is harder than it appears.

How do REITs actually fund themselves?

Through a mix of bank debt, domestic and offshore bond issuance, and equity raisings. Because the underlying assets generate stable income, REITs can carry more debt than most corporates, and the market expects gearing in a defined range – typically 25% to 40% for Australian trusts, depending on sector.

Debt maturity profile matters more than the gearing level in a stress period. A REIT with debt maturing evenly over seven years can refinance a portion each year at prevailing rates; one with a large maturity concentration faces the market on a specific date regardless of conditions. That is why weighted average debt maturity is disclosed prominently.

Hedging determines how quickly rate changes reach earnings. A REIT with most of its debt hedged for several years absorbs a rate rise gradually as hedges roll off, while an unhedged trust sees interest expense rise immediately. Two REITs with identical portfolios and gearing can therefore report very different earnings trajectories through the same rate cycle.

What is funds from operations and why does it matter?

It is the measure of cash earnings a property trust actually generates, calculated by adjusting statutory profit to remove non-cash items – principally property revaluations, which can swing enormously in both directions and reflect the discount rate rather than the portfolio’s performance.

Distributions are paid from cash, so funds from operations rather than statutory profit determines whether a distribution is sustainable. A REIT reporting a large statutory loss driven by revaluation write-downs may be generating entirely adequate cash to maintain its distribution, and one reporting a large statutory profit from upward revaluations may not.

The Australian sector has converged on a standardised definition to make comparison possible, and the useful ratio is the payout as a percentage of funds from operations. A trust distributing close to or above 100% is either running down capital or funding distributions from asset sales, both of which are sustainable only temporarily.

One structural feature specific to Australia is worth noting. Many listed property vehicles are stapled securities, combining a trust holding passive assets with a company conducting active business such as development or funds management. The trust distributes rental income with favourable tax treatment while the company retains earnings and pays tax normally. That structure explains why Australian property groups can combine steady rental income with development activity in a single listed entity, and why their distributions carry a mix of tax components that differ from ordinary dividends.

How did the sector perform through the rate cycle?

Badly on the way up and unevenly on the way down. As bond yields rose through 2022 and 2023, cap rates expanded across every sector, property valuations fell and gearing amplified the impact into REIT security prices. Trusts with higher gearing and shorter debt maturities fell furthest.

The recovery has been selective rather than uniform. Industrial and logistics recovered fastest because rental growth partly offset cap rate expansion, and specialised assets including data centres, storage and healthcare property attracted capital seeking structural rather than cyclical growth. Office, particularly secondary stock, has recovered least.

The lesson for investors is that sector allocation within listed property matters more than the timing of entry into the sector. Two REITs experiencing identical interest rate movements produced entirely different outcomes depending on whether their rental income was growing fast enough to offset the valuation effect – which is a portfolio quality question rather than a macroeconomic one.

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