The Australian love affair with residential property is longstanding and often lucrative. However, the recent release of residential yields by industry research house CoreLogic makes sobering reading at this stage of the residential property cycle for any investor focused on income.

The average annual dwelling (residential) gross property yield across combined Australian capital cities fell to 3.2 per cent. The number for the Sydney market is even lower, at 2.9 per cent at February 2017.

It is important to note these yields are gross yields and not what the investor earns after costs.

The costs rarely considered in discussions on residential property include council rates, water rates, insurance, repairs and maintenance, land tax, strata levies, letting fees and other transaction costs like stamp duty, legal and agent selling fees.

When you consider these fees over a reasonable time period, residential yields in our capital cities are materially lower than the headline numbers.

For a million-dollar residential purchase, these costs are significant, with the following figures a guide:

• Council $2,000,

• Water $1,200,

• Insurance $1,500

• Land tax $6,000

Transaction costs:

• Buying – Stamp duty $40,000 plus legals $1,500

• Selling – Agent fees $20,000 plus advertising $7,500 and legals $1,500

Ongoing investor demand for residential property suggests “investors are likely to be relying on a negative  gearing strategy to compensate for the cash flow losses,” CoreLogic head of research, Tim Lawless, told the Australian Financial Review.

Negative gearing changes on the horizon?

This situation raises two issues. First, it is unlikely the political focus on possible changes to negative gearing will abate any time soon. Many economists, commentators and political pundits believe some changes to the negative gearing regime are likely, due to budget pressures and the very real political issues of housing affordability and social equity.

Having a large part of a generation locked out of home ownership is a pressing issue for all sides of politics. While any changes are unlikely to be retrospective, planning for a refined negative gearing regime would appear to be a prudent course for prospective investors.

The Victorian government announced in March a package of measures designed to attack the affordability issue. Earlier in February, New South Wales Premier Gladys Berejiklian appointed former Reserve Bank governor Glenn Stevens to come up with recommendations on the same subject. Ms Berejiklian went a step further by nominating housing affordability as her new government’s number one priority.

The second issue raised by the current state of residential yields (low gross yields and even lower net yields) is – what are the alternative opportunities for funds allocated to property investment?

Consider your ‘plan C’

A ‘plan C’, as in ‘C’ for commercial property, is a logical and often overlooked alternative to residential property. Most nest egg builders or self-managed super funds have experience with residential real estate, be it through home ownership or investing. Putting your savings into an asset class less familiar is a natural barrier to entry.

Nonetheless, commercial property has many attractions over residential, particularly in terms of income yield. A common avenue to commercial property for many small business owners is the purchase of the business premises by the owner’s SMSF. This has much attraction, although one potential downside is the concentration of assets in one area. Should a business suffer a downturn, or worse fail, often the value of the business property can also be negatively affected.

Investing in arm’s length commercial property through a specialist commercial property fund manager is another pathway to commercial property exposure. With income yields of Australian direct property funds currently around 6.5 per cent, plus the possibility of capital gain of 7 per cent per annum, this investment option is an increasingly attractive one for those wishing to diversify out of a ‘fully valued’ residential property market.

Unlike a residential property, with a professionally managed property fund, the gross yield is also the net yield as there are no other expenses or holding costs.

Listed commercial property trust or real estate investment trusts (REITS), which is one pathway to professionally managed investment property, have enjoyed a very good run in recent years. Their value tends to be correlated to the share markets and thus volatility can be an issue.

Direct property fund, also known as unlisted property funds, on the other hand, reflect the true underlying value of the assets and have a low correlation to the equities or bond markets. This low correlation can lower the overall risk of an investor’s portfolio.

The other key difference between REITS and direct property funds is liquidity.

REITs are listed on a stock exchange and thus are liquid. Direct property funds are not liquid and usually have a five- to seven-year investment horizon. For some, this is a drawback, for others an attraction. Investors simply allocate funds out of their non-cash investment bucket. It’s almost a set and forget strategy without the constant need to worry where to reinvest the funds. The investor has comfort in knowing their savings are managed by experts and earning more than 6 per cent per annum, with any capital gain on top of this, and usually a significant portion of the earnings tax deferred.

Australians are not about to end their love affair with property or indeed residential real estate. But at a time when residential rental yields are so low, and falling, and the Reserve Bank of Australia is warning about the risks of investing in residential property, pausing to consider the income yields and options in professionally managed commercial property could be time well spent. In short, it’s time to consider a ‘plan C’ on your investment menu.

Steven Bennett, head of direct property, Charter Hall Property Group