Sydney, Melbourne house prices could fall 10 percent: Capital Economics

House prices in Sydney and Melbourne are overvalued by up to 30 per cent, and could experience a 10 per cent correction in prices once the RBA raises interest rates, according to a leading economist.

Economist Paul Dales of Capital Economics has done the numbers using a measure called the HPE ratio, or a "normal" house price to earnings ratio.

The other capital cities of Hobart, Brisbane, Adelaide and Canberra were also overvalued - by as much as 10 per cent.

The forecaster said prices were in line with fair value in Perth while Darwin could be undervalued.

Capital Economics noted that the current average house price to earnings ratio for the eight capital cities of 5.8 was still much higher than the historical average of 3.6 for the 36 year period from 1980 to 2016.

The consultancy said that most analysts look at house price to income ratios to determine whether real estate is overvalued. Instead, Capital Economics used the HPE measure to arrive at its conclusions.

The analysis said that in spite of the higher HPE ratio, house prices in Sydney and Melbourne wouldn’t go into a free fall because a "structurally lower" level of interest rates at present compared with that of the 36-year period meant buyers were now willing to accept a lower annual return from housing and were also willing to pay more for housing relative to their incomes than in the past.

The structural decline in interest rates has raised the “fair-value” or “sustainable HPE ratio”, noted Dales.

"Our view is that prices in Sydney and Melbourne will broadly stagnate or fall modestly over the next two years and that prices won't fall significantly until the RBA starts to raise interest rates, which might not happen until late in 2019. Thereafter, prices in both capital cities may fall by around 10 per cent."

Other capital cities, where the values are not so inflated, might not suffer price falls at all, Dales added.

"As long as disposable incomes continued to grow in each of those cities, then prices may not need to fall much, or at all, for their HPE ratios to move back to sustainable levels.” 

The analysis follows statements by veteran real estate agent, John McGrath, who recently said that the Sydney market was overvalued but ruled out a sharp correction.