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House prices are still key to buy-to-let

So how likely is that? Of course, this question isn't just vital to landlords; it's of financial interest to anyone who owns or aspires to own their home - about four in every five Britons, according to a recent survey by YouGov. Hence the question of house prices always provokes such passionate debate - far more than any other question in personal finance. I wish I didn't have to wade into it, but in the absence of decent income returns from housing the question is too important to the investment case to shirk.

There seem to be two broad views. Many Britons instinctively assume that 'house prices always go up in the long run' because that is the experience of their life times. Another group asserts that houses are substantially overvalued and prices need to fall. Paradoxically, this too is often conditioned by individuals' own experience, because houses were so much cheaper when they bought theirs.

The bears take their cue from the consultancy Capital Economics, which specialises in doom-mongering. It forecasts 5 per cent falls in the Nationwide index in 2012 and 2013 and a 3 per cent fall in 2014. Its argument centres on one key graph, showing the long-run house price to earnings ratio since the mid-1970s.

This graph shows that houses still cost a higher multiple of average earnings than has historically been typical. The implication is that house prices need to fall, or earnings need to rise, to restore the balance. Because it relies on the assumption that price ratios 'revert to the mean', this view is philosophically aligned with 'value' investing, whereby stock pickers buy stocks that trade on lower price-earnings multiples and sell stocks that trade on higher ratios.

Meanwhile, the bulls are 'growth' investors, citing structural trends like demographic change and immigration (reports of a population boom in Britain surfaced this week), as well as the Malthusian spectre of limited supply, to argue that the strong past performance of residential property in the UK will continue. The bulls concede that the near-term outlook is pretty dismal, due to the double-dip recession. But they assume house prices will soon start rising again. The research team at Savills, for example, expects a 2 per cent fall in 'mainstream' house prices (ie excluding the prime markets) this year and a gradual recovery in 2013-2015. Knight Frank's forecasts are slightly lower, but follow the same general pattern.

Both bull and bear cases raise more questions than they answer. One problem with focusing on the house price to earnings ratio is that there is no clear mechanism to restore it to its long-run average. Affordability, the most obvious mechanism, depends less on house prices than on interest costs, and thanks to rock-bottom mortgage rates these are at their lowest in a decade, relative to earnings.

A more fundamental objection to the bear case is that society will plausibly spend a greater share of its income on space as it gets richer. Capital Economics points out that this argument was also made during the US housing bubble, and US house prices have since fallen back to their long-run earnings multiple and possibly below. But housing supply is infamously responsive to high prices in the US and unresponsive in the more densely populated UK. This distinction was carefully articulated in a recent paper by David Miles, a member of the Bank of England's Monetary Policy Committee, who concluded real UK house prices would continue to rise as long as both the UK population and economy kept on growing.

The house-price to rent ratio - or its inverse, the rental yield - is a better valuation measure because it takes account of the demand and supply dynamics. The problem here is a lack of reliable long-term data on rents. Capital Economics reports that houses are overvalued relative to rents, but Simon Ward, an economist at fund manager Henderson, uses national-accounting data since 1965 to argue the opposite.

The problem with the bull argument is that it raises uncomfortable questions about the future. If house prices are a rising multiple of incomes, how will first-time buyers afford deposits? Will the housing market become dependent on inter-generational transfer of equity, with grand parents bequeathing property exposure to their grand-children? Mr Miles thinks "hybrid debt-equity contracts" between lenders and buyers, such as those offered by CastleTrust, will become more common.

It may be a result of indecisive character more than of keen judgement, but my personal instinct is to occupy an Obamian mid-ground in this debate. It seems safe to assume that house prices will continue to fall, relative to consumer prices and incomes, as long as the economy remains weak - and quite possibly until the banking system has worked through its bad debts, which could take another half decade. But I also find it plausible that house prices will rise faster than earnings; I see nothing sacred about the famous house price to earnings ratio.

That suggests investors should operate a wait-and-see approach. Housing is still a sensible long-term buy. But there may be better entry points to come.