A post in May suggested that house prices were bottoming, on the basis that the national rental yield had returned to its long-run average while low interest rates would limit distressed selling, so housing was unlikely to become significantly undervalued.

Valuation is often assessed using the house price to income ratio, which remains far above its long-run average. This was the basis of a Fitch Ratings forecast this week that prices will fall by 20% from current levels. As argued in the earlier post, however, the "equilibrium" level of the ratio has trended up over time, partly reflecting the pressure of an expanding population on constrained supply.

An alternative approach is to use rents rather than income as the basis for comparison. Rents already embody supply / demand fundamentals. People need to live somewhere – the choice is between buying your own home or renting, not whether or not to spend income on housing.

An economy-wide rental yield can be calculated from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock. The yield has fluctuated around a stable level, averaging 3.6% between 1965 and 2007 – see chart. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The earlier post estimated that the yield had risen to 3.8% by April 2009, suggesting small undervaluation. This assumed that the value of the housing stock had fallen by 21% from the end of 2007, in line with the Halifax index. Subsequent official figures, however, showed a smaller decline during 2008 while prices have recovered significantly since the spring, with the Halifax measure up by 6% from its April low by September.

Incorporating these changes and recent data on rents, the national yield is estimated to be 3.4% currently, suggesting house price overvaluation of about 5% based on the 3.6% long-term yield average – far below the 24% claimed by Fitch. This deviation can be eliminated without a fall in prices since rents are rising – by 7% in the year to the second quarter.

Rather than renewed weakness, further price gains appear more likely near term – improved mortgage availability and rising consumer confidence may lift demand, while low interest servicing costs, government financial support and negative equity will continue to limit supply. The risk of a mini-bubble would increase if the Bank of England were to inject more liquidity into the economy by extending its gilt-buying operation next month.