Who can afford to pay 50 per cent more for a house? And, of those who can afford it, who would? The same goes for rents. These are the big questions that few people seem to be asking as Australian house prices approach historic highs and the credit crisis bites.

A raft of analysts, mostly banking economists, in the past few months have forecast a 20 per cent to 50 per cent rise in house prices and rents based on supply and demand fundamentals.

They argue that supply is tight and demand is rising, thanks to continued immigrant inflows and the influx of Generation Y into a red-hot housing market.

However, this argument fails to incorporate key affordability issues, the fact that credit supply is tightening, and the possible impact after 2010 of a global slowdown on a highly leveraged economy.

Something has to snap

Wage growth has not kept up with rises in house prices, rents, petrol, food and interest rates. Household incomes are not endlessly elastic. At some stage, something has to snap, regardless of supply and demand. The question now, is when?

Let's look at the facts:

• House prices have experienced a compound annual growth rate of 8.9 per cent in the past five years
• Disposable income has only experienced a compound annual growth rate of 2.9 per cent in the same period.
• Initial loan value ratios have jumped from 46.5 per cent to 65.6 per cent.
• ABS statistics show the number of housing finance approvals fell 5.9 per cent in February to their lowest level in four years. The value of approvals fell 9.4 per cent.
• Since then, the Reserve Bank has raised rates twice.
• Bank defaults are rising

Lead Banking Analyst for JP Morgan Brian Johnson seriously questions the capacity for household budgets to stretch further, citing the dangerous mix of high household debt levels and rising interest rates.

"Australian households are carrying a bucket-load of debt," says Johnson. "Heading into 2008, they were carrying high LVRs on housing lending.

"Since then, we have had three 25 basis-point rises in official interest rates and 40 additional basis points from the mainstream banks. Non-mainstream banks have lifted interest rates even further.

"In this environment, it seems improbable that housing prices can rise much further. There is evidence of tight supply and strong demand for rental properties but this is unlikely to drive price rises of the magnitude that some are forecasting."

House prices can fall — exploding the myth

Johnson said it is a myth that house prices haven't fallen and can't fall and notes large pools of mortgages, originated by non-bank brokers in particular, have led to increased foreclosures and lower house prices in pockets throughout Australia.

"Prices in Sydney don't always go up. They can do nothing in a decade and then double," he says.

Indeed, historical economic data showed that during the Great Depression of the late 1920s and early 30s, Australian property prices fell 30 per cent. Economists predict prices in Australia could fall 10 per cent on a slowdown, 30 per cent during a recession and up to 50 per cent in some regions.

Household debt raises the stakes

Johnson adds that the situation with household debt is alarming.

"Given the Australian use of negative credit reporting, it is hard to gain a picture of overall indebtedness. Rolling credit card debt is a huge issue. Most people try and pay off credit cards within the month but we know that credit card debt has rolled out to three months of disposable income."

Interestingly, the banks are the main supporters of the price-rise rhetoric, all issuing economic outlooks forecasting price rises. This has eery echoes of early 1990s bank forecasts when they insisted that economic growth would continue despite calls from every sector for recession. Are they again talking up their books?

When assessing the future of house and rental prices, there are several possible scenarios.

Banks moved the goalposts

However, this leaves little margin for error, particularly if fuel and food prices keep rising. It is also a patently false assumption as the US sub-prime crisis is showing. While the Australian market differs slightly from that of the US, it is still ultimately subject to the same fundamentals. If mortgage repayments are too high, or asset prices fall, people can and do go to the wall.

The great illusion

There is a shortage of housing in Australia, exacerbated by immigration and tight land supply. BIS Shrapnel director and chief economist Frank Gelber said an annual construction shortfall of 30,000 dwellings was set to double to 60,000 by June this year and rise to 129,000 by June 2009.

But the supply-demand dilemma Australia faces is largely an illusion determined by government and private sector policies. There is probably greater elasticity in supply and demand at this point than there is in household budgets.

Pushing the supply lever

The supply side of the equation can be changed. Governments could increase land supply. This takes time to flow through but it would certainly ease upward pressure on prices.

Improved supply may remove a floor under house prices at a time when the market can least afford it. It requires a delicate balancing act. The government is working on supply, but analysts believe it will not be fast enough to stall another spike in prices.

Demand can be changed

But demand can also be altered. People under financial stress historically have been inclined to alter spending and lifestyle patterns. In the past two decades, the numbers of people per household have declined as people have enjoyed relative affluence. These trends could easily reverse. People can share accommodation, move into smaller houses (slum landlords rejoice), move back in with parents or move out of the cities and into the country.

The Government could also cut immigration, which is at record highs (although this is unlikely and would affect short-term growth.

Interest rates also affect demand — and these can be eased or tightened at the behest of the central banks.

A sucker's rally

Given the high levels of household debt and tightening of credit policies in the wake of the credit crisis, it is likely that any rise in house prices would require investment from high net worth individuals or low-debt-bearing new entrants. Should rents rise, some property investors may also be tempted back to the market, but again, their balance sheets would need to be very healthy.

If this were the case, then any rise in house prices would have all the hallmarks of a sucker's rally — particularly if interest rates pull back briefly. Just before sharemarkets collapse they tend to spike sharply on low volume, luring those who believe the market will continue to rise indefinitely and in defiance of fundamentals. A price rise on low volume is unsustainable and, given the high Australian LVRs, we know that very few people can afford to take on more debt.

Visit our mortgage centre to find out if you could trim your mortgage costs.