Prices are also vulnerable to rate rises or mooted changes to negative gearing.

The Reserve Bank of Australia has argued that demand from foreign, especially Chinese, buyers will support the housing market while some forecasters say growth is still possible in some areas.

Too expensive to keep running

McMillan says Sydney prices have slipped between 2 per cent and 5 per cent each time the affordability index has been this high. The rise in 2008 (shown in the graphic) was a result of banks slashing interest rates because of fears that the global financial crisis would stall investment activity.

He is unwilling to put a figure on any future decline, or whether the market will stagnate at current levels for an extended period.

Sydney property prices have reached a classic peak.

"The low interest rate environment means it is hard to see how buying conditions will be improved in the short term," he adds. "The market is just too expensive to keep running. The bulk of potential buyers cannot afford to compete. We will have to see three to four years of wage growth before it returns to normal levels."

Different measures are used for Melbourne and Sydney because they provide the "most compelling" evidence of the pressures that are likely to slow demand, he says.


SQM Research, which monitors property prices, says oversupply of house and land packages in Sydney's south-west suburbs and other outer regions could also put downward pressure on prices.

Auction clearance rates, which remain a healthy 70 per cent, reflect "inner ring" suburbs where auctions are popular and demand remains strong, partly because of overseas buying.

The correlation between property prices and income is widening.

Limited investment value

Most housing, particularly in Sydney's outer areas and north-west and south-east, is being sold by private treaty sales, where a property is listed for sale with an asking price.

Growth pressure is also being eased by council rezoning to increase housing to cope with population growth.

In Sydney, median weekly incomes during the past eight years have increased from $1251 to $1513 (a 17 per cent increase), while house prices have nearly doubled from $546,000 to more than $1 million.

In Melbourne, where prices in popular suburbs have tripled over the past decade, prices have risen by seven times the median income since 2010, according to the Australian Bureau of Statistics.


"While you cannot tell how far a market will run, it is clear there is limited investment value in Melbourne and that has been the case for some time," says McMillan.

Price stagnation, which means static prices, or a minor correction is the "only logical outcome", he says.

Properties in school areas sell faster

"Generally speaking, negative gearing into the Melbourne market is not a prudent strategy at the moment."

Melbourne is also a tale of two cities, with some postcodes having an oversupply of property and others struggling to meet demand.

For example, rental returns have been flat for about six years for inner Melbourne apartments and land-house packages on the suburban fringes where there is an over-supply.

By contrast, there is a shortage of quality housing in Melbourne's south-eastern suburbs' blue-chip school belt.

Nicholas Smedley, chief executive of Steller, the largest supplier of medium density apartments in Melbourne's south-east, says properties in the catchment for popular McKinnon High School sell 50 per cent faster and at a premium to those outside.


Three times national average

Smedley says he has never had a rental vacancy in the school catchment area.

David Higgins, an associate professor in property investment at RMIT University, says property prices in Melbourne suburbs near popular schools and universities for foreign students have increased in value by three times the national average.

Higgins says suburbs in Melbourne's south-eastern suburb of Clayton, which borders the Monash University campus, have consistently out-performed.

Rents in Perth and Darwin, where populations soared during the recent mining boom, are down about 10 per cent during the past 12 months, according to SQM Research.

"The property investment sector contains considerable risks for investors," says Martin North, principal of Digital Finance Analytics, a company that monitors consumer and financial trends.

Highly geared investors most at risk

He says modelling on the impact of small interest rate rises "shows that things get worse – such as financial distress and defaults – very quickly, particularly for higher loan-to-value ratios".


Those most at risk are portfolio investors, typically with more than two properties, that are highly geared.

"About one quarter of property investors said they would have difficulty meeting any additional interest rises - even 0.5 per cent - implying they are already under financial pressure," says North.

More than 50 per cent of investors would be in "potential difficulties" should rates rise by 3 per cent, he adds.

Investors in Tasmania were most concerned, followed by South Australia and the Australian Capital Territory.

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