One way of assessing the downside for house prices is to ask how much further they would need to fall to achieve either a “fair” level by historical standards or a given level of undervaluation – on the assumption that markets typically undershoot on the way down.

The discussion is usually couched in terms of the house price to earnings ratio but – as explained in an earlier post – the rental yield on housing is a superior measure of valuation.

The chart below shows historical National Accounts data on the rental yield together with a current estimate based on prices having fallen 11% from their peak late last year (as suggested by the Halifax index).

The current estimated yield of 3.4% compares with a long-term average of 3.6% – a reasonable estimate of “fair value”. Assuming no change in rents, prices would need to fall a further 6% to bring the yield up to the average. The RICS survey of letting agents released today indicates that rents are still rising so a smaller decline would be possible.

Now suppose the market undershoots to the same extent that it overshot in 2007. The yield got down to 2.9% last year – 70 basis points below the average. A rise to 70 b.p. above the average would take it to 4.3%. This would involve a further 21% fall in prices from current levels, assuming unchanged rents.

The bottom line? A further 10-20% fall in prices would bring them to an attractive level for a long-term owner or investor.