UK house prices are no longer expensive relative to a measure of "fair value" based on rents. Prices fell significantly below fair value during the major house price busts in the 1970s and 1990s but a big undershoot is unlikely in the current downturn because low interest rates will limit forced selling.

The notion that housing is no longer overvalued is controversial because the house price to income ratio remains far above its average since 1965 – see first chart. This average, however, is unlikely to be a good guide to fair value because the ratio has trended higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

An alternative approach is to use rents rather than income as the basis of comparison. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

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 – second chart. The yield averaged 3.6% between 1965 and 2007. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The housing boom pushed the rental yield down to 2.8% at the end of 2007, suggesting that prices were then overvalued by about 29%, based on the 3.6% long-run average. The Halifax index has fallen by 21% since December 2007, while rents had grown 6% by the fourth quarter of last year. These changes imply a current yield of about 3.8%, consistent with small undervaluation.

The rental yield rose well above the 3.6% long-run average during prior housing busts. If the overshoot in the current downturn were to equal the undershoot during the boom, the yield would rise to 4.4%. This would be consistent with a further fall in prices of about 14%, assuming unchanged rents. A decline of this order is widely expected.

Such a scenario, however, is probably too pessimistic. A key difference from prior busts is the low level of mortgage interest rates, which is allowing many struggling borrowers to continue to service their loans. The Council of Mortgage Lenders last week reported that repossessions and arrears cases rose by less than feared in the first quarter. The CML intends to revise down its earlier forecast of 75,000 repossessions in 2009.

With less distressed selling, downward pressure on prices from rising supply is much smaller than in prior downturns. According to the Royal Institute of Chartered Surveyors, the number of unsold homes on the books of the average estate agent stood at 69 in April – far below peaks of 166 and 196 in the last two major housing downturns. Meanwhile, buyer enquiries have picked up recently.

Translating buyer interest into transactions depends critically on mortgage availability. The last Bank of England credit conditions survey reported tighter mortgage supply in early 2009 but expectations of an improvement in the spring. Signs of a stabilisation of prices could have a self-reinforcing effect by encouraging lenders to reduce current high deposit requirements, designed partly to protect against negative equity.

Of course, if house prices bottom at a smaller discount to fair value than in previous downturns, this also implies less scope for a significant recovery over the medium term. Moreover, an increase in supply may have been postponed rather than cancelled – "zombie" borrowers will have their life support turned off once the MPC starts raising interest rates.