Does the 1% rule work in Australia? No. But maybe rental yield is not the whole picture - instead, look at total returns off holding property. Taxation laws play a huge part, as well!
With property, I've noticed in WA in particular you can only operate on a buy and hold strategy because you pay stamp duty when you buy and when you sell, which I believe is therefore twice what you pay in any other state in Australia.
I'm not sure that's true. See
http://www.finance.wa.gov.au/cms/content.aspx?id=2077: "The person liable for duty (usually the purchaser or acquirer)"... etc etc. If I read that right, if you are up/downgrading you will pay duty twice, once upon buying the first property, and once upon buying the second property, but you are not charged twice with respect to any one property, which is similar to other states.
I am currently doing my research very carefully with regard to buying vs renting in WA. The population growth factor seems to be driving demand extremely aggressively (Australia's population growth rate is somewhere around 1.6% annually, which is almost 50% above the WORLD average, let alone the OECD average), while supply is constrained by large property developers squatting on land / strict planning schemes restricting release / a lack of government support for infrastructure development / NIMBYs preventing high-rise development / insert your preferred political punching bag here. I just don't see how pressure on either end is going to cease any time soon, which tells me to buy, regardless of overvaluation!
One article I saw charted Melbourne's property market from somewhere in the 1800s, and found a 10% nominal growth average year-on-year from that time. It also suggested that a similar analysis of UK property had a similar trend dating back hundreds of years. After I stop procrastinating and write my damned assignment, I'll see if I can dig it up for your edification.
I also think that the 1% rule assumes the presence of property/land tax, which Australia lacks in any meaningful sense and which would drive property values down (and therefore yields up) by increasing the opportunity cost of holding property. The recent Henry Tax Review suggested we put in a land tax - and was duly ignored. Alternative thought: maybe due to negative gearing, Australian property yields are capitalised into the value of the property? (Does that even make sense? Needs further thought.)
That said, I find it very difficult to justify the job lockdown that buying implies, even if I figure I could clear the loan in 5 years or so. I still have plenty of wanderlust left in me, and that amount put into the property could turn up a very pleasant contribution to the annual budget in dividends. It's a shitty choice either way: put up with weak tenure and ongoing rent increases, or be tied down and pay for council rates and maintenance? Sigh...
I suspect the optimal way to get into property in Aus is to buy an investment property while renting to take advantage of negative gearing while improving the property to your liking (air conditioners and landscaping for all! Woo!) before moving yourself in. This assumes the tax benefit you gain from tax-deductible interest and improvements is not outweighed by something like the First Home Owner's grant and stamp duty exemption. Different interest rates may apply on the loan, too. Or maybe buy, and rent out rooms for a while. Best of both worlds? Note to self: look up tax treatment of renting out rooms in one's primary place of residence, or ask Tax Law lecturer. He'll love a curveball like that!
EDIT: I thought of more things to add. =)
EDIT 2: If you have the choice to buy cash or put down a deposit and use the remaining cash for investing, you could think of using a mortgage as basically a margin loan on your shares, at home loan rates (2-3% lower than normal margin loans) and with better terms (no margin calls). If your shares return more than your mortgage rate and you can handle the cash flow impact, that may be a good way to use leverage. Just remember it is still leverage, with the risks inherent.