An earlier post argued that UK house prices needed to fall by a further 6% from their July level to bring the rental yield on housing back to its long-term average, assuming stable rents. If the rental yield were to overshoot the average to the same extent that it undershot in 2007, a decline of 21% would be necessary. These could be considered best and worst case scenarios for house prices.

The two scenarios would imply peak-to-trough falls in house prices of 16% and 30% respectively.

Prices dropped by a further 1.8% in August, according to the Halifax index. The required additional declines are therefore now 4% based on the long-term average yield and 19% in the yield overshoot scenario.

The chart below compares the scenarios with the last three house price busts – 1973-77, 1980-82 and 1989-96. The comparison is in real terms – relative to the retail prices index – because general inflation carried a greater burden of valuation adjustment in the prior episodes.

The scenario paths assume that remaining house price adjustment occurs smoothly over two years while the RPI rises by 3% per annum.

In the best case scenario the peak-to-trough decline in real house prices would be much larger than in 1980-82 but less severe than in 1973-77 and 1989-96. The worst case scenario would imply greater damage even than in 1973-77.

Restricted mortgage availability and coming labour market weakness clearly suggest an outcome closer to the worst case. However, prices are now falling faster than at the comparable stage of previous busts. If the decline continues at its recent pace, nominal prices could be nearing a trough by next spring.