Ed Stansfield of Capital Economics goes on to report: " for context, that figure is some 17% below the Nationwide’s estimate of average house prices in January of £150,500 and 33% below the October 2007 house price peak.
What’s more, we think that house prices will ultimately fall 10% - 15% below this fair value level.
• We look at three different metrics to derive an estimate of fair value house prices. These are the divergence of real house prices from their long-run trend, the house price to earnings ratio and an assessment of the level of rental yields that would make people indifferent between owning and renting property. Depending on the assumptions made, these three metrics suggest that fair value house prices could lie in a fairly broad range that runs from £115,000 to £135,000.
• However, we think it is reasonable to assume that fair value can be represented by either a gross rental yield of 8%, a house price to earnings ratio of 4 or the level of a long-run trend in real house prices that rises by 2.25% per annum. Each of these assumptions generates a consistent estimate of the current level of fair value house prices, namely £125,000.
• Of course, that cash figure is not constant over time. For example, if rents were to fall this year, house prices would also need to fall to keep rental yields constant, while higher rents would boost the sustainable level of house prices.
• The fair value level for house prices will also be affected by changes in the interest rate environment. Our 8% figure for fair value rental yields assumes a mortgage rate of 6% - not unreasonable as a long-run assumption in normal economic conditions. But, as official interest rates approach zero, that assumption looks far too high – 3% or 4% might be closer to the mark. As the cost of mortgage finance falls, so will the breakeven yield on property.
• The current level of residential yields has already triggered a modest recovery in buyer interest. As yields continue to rise, that interest is likely to grow. The rise in demand may help to prevent prices undershooting fair value estimates by 30-35% as they did in the early 1990, but it is unlikely to prevent house prices falling at least some way below fair value. Our forecast of a 40-45% drop in prices envisages a 10-15% undershoot, in line with the mid 1970s and early 1980s corrections."
