House prices 'on the precipice'

HOLD on to your hats, homeowners. House prices are going to fall next year. So says City think-tank Capital Economics, which challenges the views of the big building societies and housebuilders.

Capital Economics thinks the property price balloon is about to burst. It predicts that prices are going to crash 20% from their peak over the next three years.

The slump will start in the middle of next year. By the final quarter of 2004, prices will be down 2% on the same three months of this year.

Nonsense, says the Centre for Economics and Business Research consultancy. It cannot see what will trigger a slump and sides with building societies the Nationwide and the Halifax, predicting house price inflation of nearer 8% or 9% next year.

So why are the experts so far apart in their views? First, they interpret history differently. Second, they are at loggerheads over how human nature will react.

Where several of them do agree, however, is that next year is going to be crunch time.

Housing market bears warn that homeowners have become over confident. Buoyed up by two-and-a-half years of falling interest rates and double-digit house price inflation, they think the market can only go up.

'That's the sort of sentiment that gets embedded when a bubble has formed,' says Capital Economics' property economist Ed Stansfield.

He argues that with house prices now running at 5.5 times average earnings, a sharp correction is looming. For decades the housing market has moved in boom-and-bust cycles, with the price-to-earnings ratio always falling back to its long-term average of 3.5 times pay. This key ratio is at a record high.

But the CEBR argues that just because house prices have crashed in the past, does not mean they will crash again. It says the last market collapse in the 1990s was caused by the combination of soaring interest rates and high unemployment.

CEBR economist Andrij Haluska said: 'At the moment we can see either one or the other happening. It's extremely unlikely they will both come together.'

He says with interest rates so low, people can still afford to keep paying their mortgages - even if the size of the debt in relation to their income is getting bigger.

And even if house prices fall slightly, the situation will stabilise because there is such pent-up demand due to the housing shortage.

Capital Economics points out that supply was not a factor between the 1989 housing boom and the 1990 housing crash, when the number of houses hardly changed. 'Competition may give people a false sense of security,' added Stansfield.

He thinks 'the impact on human psychology will be quite marked' if interest rates rise as predicted to around 4.75% next year, combined with the realisation that 25% house price inflation is a thing of the past.

The bulls argue that modest interest rate rises will have no effect because households will still be able to afford the small rise in their monthly payments.

But if there is a sharp rise in the base rate by the end of 2004 - as the world economy gathers pace - the rise in mortgage costs could yet prove damaging.