There’s a simple reason why many experts reckon the rapid house-price growth of recent years cannot continue in Sydney and Melbourne in 2016: households won’t be able to afford it.

There are lots of ways to analyse what is the right level for house prices, none of them perfect. But a key way of valuing property is by comparing the price of houses with the incomes of households. After all, it’s households who buy and sell homes.

And guess what?

The ratio of house prices to household incomes in the country’s two biggest cities have shot up especially sharply since the Reserve Bank started cutting interest rates four years ago, and are well above their longer-term averages.

There’s a clear reason for this: very cheap debt. But common sense also tells you this trend cannot continue at its recent pace, especially at a time when average pay packets are growing very slowly.

The graphic shows National Australia Bank economists’ estimates of household income in each state, compared with the median house price, and how these have changed in recent years.

It shows the house price to income ratios for both Sydney and Melbourne have risen sharply in the last four years, and both are well above their 10-year averages.

So, why have prices grown so much faster than households’ pay? And what are the chances of this trend continuing?

A key reason for the rise in price-to-income ratios is that home buyers are borrowing more money from the bank.

Recent numbers from CommSec showed the average new home loan had surged to $379,400 after growing by 15.4 per cent in the year to September – the fastest growth in 12 years.

This is what you’d expect when interest rates are at such lows, because borrowing has rarely been this cheap.

Nonetheless, the growth in lending by banks, and the rise in house prices that this has fuelled, probably won’t continue at this pace, because affordability will become more of a constraint.

As home buyers in Sydney or Melbourne can attest, housing affordability is already a challenge.

Barclays economist Kieran Davies estimates that mortgage repayments will rise to 29 per cent of household income nationally next year, up from lows of 25 per cent in 2013.

“Housing activity should weaken later next year in response to the deterioration in housing affordability,” Davies says.

The crunch is far greater in the states where prices have risen the most: NSW and Victoria. Davies calculates that the share of household income gobbled up by mortgage repayments is already 37 per cent in NSW and 35 per cent in Victoria.

Figures like that help to explain why a growing number of experts are predicting the recent softness in the housing markets of our two biggest cities has further to run.

Posted by Clancy Yeates – Money Manager (Fairfax) on 13th November, 2015