The good news - house prices will rise again (and then they'll fall)

In the mid-19th century, big names in the building business were failing. Developers on the Grosvenor Estate in Belgravia, London, such as Thomas Cubitt were in financial trouble and Thomas and Joseph Cundy went bankrupt. A speculative bubble in railway stocks burst in 1847, causing a great slump. No doubt, Victorian pundits complained of the excesses of the speculators and called for an end to boom and bust, greater regulation of investments and more accountability among those responsible

More than a century, and many booms and busts later, this is exactly what was said after the Barber boom and the subsequent banking crisis, property-market crash and recession of 1974; and after the Lawson boom, housing-market crash and recession of the early 1990s. The aftermath of the Brown boom looks like being no exception. After the over-exuberance of the growth years, there always seems to be an outbreak of sober under-exuberance.

It is in this soil that the seeds of the next boom and bust will be sown. Even with deep recession looming and the Governor of the Bank of England warning the nation of very difficult times ahead, it is hard to see how we will stop the housing market crash of 2027.

To those forecasters expecting a one-off 40 per cent drop in house prices, this must seem like arrant nonsense. But if we pretend that we won't see another house-price boom starting in the next decade, we will not be able to nip its worst excesses in the bud when it comes.

The pessimists have, on the whole, got the extent and timing of the present downturn right - but not necessarily for the right reasons. They seem to think that because the roots of the credit crisis were in the US housing market and excessive sub-prime mortgage lending, the same is true in the UK. But the roots of Britain's downturn lie in the credit crisis and the consequent withdrawal of funding by lenders, not the other way round.

The UK housing market really is a different country: in the US as many as one home-owning household in 16 has defaulted on its mortgage or faces repossession, compared with fewer than one in 200 in Britain.

To predict that the UK housing market will fall by 40 per cent and remain at these new, corrected levels is to ignore the role of finite supply and the use of equity.

The most frequently used indicator of property market overheating is the house price to income ratio. In the 1970s and 1980s loans averaged around three to four times earnings, causing the pessimists to argue that the recent levels of six or seven times are unsustainable. What the pessimists ignore is the increased use of equity in the housing market. Mortgage lending in the 1960s and 1970s facilitated a huge transfer of property ownership from landlords to owner-occupiers. Those home-buying pioneers have been paying off their mortgages and house-price inflation has increased their purchasing power in competition with new entrants. So it has always been inevitable that, in the face of finite land and property supply, the relationship between incomes and value (the basis of having a mortgage) would become disconnected as owners became less mortgage-reliant.

Since 1992 the number of owner-occupiers has grown very slowly, at around 0.8 per cent per annum. They still constitute about 70 per cent of households, as they did in 1992. What has changed is the amount of equity built up by these households. Around 40 per cent of owner-occupiers own outright, without a mortgage. The low number of new entrants to owner-occupation is the result of “deposit poverty”, the inability of would-be first-time buyers to raise equity. This has increased demand for renting. The biggest, unsung, growth area since 1992 has been the privately-rented sector, which has grown at an average of more than 3 per cent a year, expanding from 9 per cent of all stock in 1992 to 13 per cent in 2007.

Another frequently used indicator of housing-market overheating is the cost of mortgage servicing. The story of the Lower East Side of New York at the end of the 19th century demonstrates that there has never been a rule that says that people will spend only a quarter of their income on housing - although this has been the late 20th-century average in Britain. An area inundated with new immigrants combined with relatively scarce (slum) housing meant that tenants were paying more than fourfifths of their wages on rent.

The Lower East Side story reveals that when the supply of the homes that people want, in the places that they want them, is scarce, they will use all their purchasing power to secure them. British homebuyers have been like characters from The Flintstones, using wads of cash instead of clubs to beat their neighbours to a cave.

This then begins to get to the root of the issue; if land supply is finite (and new housing supply is set for one of the biggest downturns in recent history), land and property values will always behave in the same way at the end of an economic cycle, being driven up in value along with other asset prices. In the face of such rises, human nature ensures that purchasing turns speculative - and another bubble is born.

The housing bubble has burst, but it has burst simultaneously with stock markets. However, the underlying demand for housing is clearly revealed by the continued increase in rents in most areas.

By the end of 2009, house prices will probably have fallen 25 per cent from their peak. They will be about two thirds of the way there by the end of this year. In 2010 the market looks likely to bump along the bottom, although we may see the first signs of recovery.

Where will that recovery come from? In previous downturns overseas investors have been first to return to the fray, encouraged by a weak pound. Some are eyeing the exchange rate even now. They may be joined by domestic investors who are worried about the security of funds in banks and see bricks and mortar as a better prospect than the stock market or bonds. Some are already reappearing in auction houses looking for rental yields above 5 per cent.

What they will not be buying are flats in over-supplied city centres, where recent investors have caught a cold. As in all recoveries, the best will out-perform the rest. Expect the first green shoots in London, the South East and the best university towns and cities.