The house price boom in Australia’s two biggest cities is crunching a key measure of return for property investors: rental yields.

If you’re thinking about investing in the hot parts of market, especially Sydney, it’s worth considering this fact, alongside any prospect of future capital gains.

One argument often made in favour of property investment in Sydney and Melbourne is that the rental markets are still pretty tight in most areas. There is strong demand for housing, and this is pushing up rents.

In Sydney, for instance, average rents rose 3.3 per cent in the year to March, which was the fastest in the country, CoreLogic RP Data says.

That may sound like good news to a potential investor (though not for tenants), but it’s not quite that simple.

True, the fact that rents are rising and vacancy rates are low should bode well for landlords looking to lease their homes.

But if you’re thinking about investing in these markets at a time like now, when prices are rising fast, it is also worth thinking about rental yield.This is the annual return that a landlord entering the market at today’s prices gets on their investment.

Gross rental yields for houses are at near record lows of 3.4 per cent in Sydney and 3.2 per cent in Melbourne.

They are higher for apartments, which typically make less capital gain, though the Reserve Bank has pointed out that the rental market is looking soft in inner-city Melbourne flats.

As prices soar, yields will fall if rents are unable to keep pace with the growth. That is exactly what’s been happening during the past couple of years. The average rental yield for a house in a capital city has fallen from 4.3 to 3.6 per cent – and remember that is the return before costs such as water bills and council rates.

Investors should take yield into account, because it represents the type of return they will get on their investment until they are ready to sell.

Of course, many property investors are also banking on long-term capital gains, so a smaller yield is not necessarily a deal-killer.

And these things are relative. Dividend yields of shares have also been dragged down by investors bidding up share prices. It’s all being driven by a global surge in asset prices, which has in turn been triggered by record low interest rates.

But all the same, signs like this shouldn’t be ignored. Capital gains is a big reason many investors buy properties, but rent is the most immediate source of return.

Posted by Clancy Yeates – The Age on 14th April, 2015