The start of the house price recovery seen in the higher-value equity-driven markets in London will feed down into other areas as the economy starts to grow. It’s a pattern that is likely to mirror the last cycle.

Already, the green shoots stories show how the scarcity of housing is supporting prices in some markets. With further modest adjustments to prices at the lower end of the market, house prices are likely to have largely bottomed out within the next 12 months.

However, with supply set to remain suppressed for some time, recovery in the market will be dictated by what happens on the demand side. And the scale of the upside may not be as great this time around. Any recovery is likely to be gradual and spread over the next few years.

Opinion has been divided over the extent of the housing downturn and the factors that influence it. Forecasts for how far values may fall have ranged from 20 per cent to 50 per cent. The latter figure is based on expectations that house prices will need to readjust their values to a realistic multiple of average income. But while this may be the case in other asset classes, that logic does not always follow in the housing market.

Depending on how the health of the economy pans out, price falls may not be as bad as the most bearish forecasts.

As in previous economic cycles, the outlook for the economy – and this includes unemployment – together with the availability of mortgage finance are crucial influences on the housing market in the near term. But there are three very specific factors that will also influence the trajectory of house prices and the shape of the recovery.

The first factor is owner occupiers. It is they, rather than investors, who are responsible for setting prices. While strong demand from investors and speculators distorted prices for city centre flats, this frenzy was not mirrored across the wider housing market. New-build flats, for example, have seen falls of up to 40 per cent as prices realign from their investor-driven highs. By contrast, the average three-bedroom owner- occupied home, which accounts for half of the market – and, arguably, should be seen as a benchmark for pricing – has seen a less severe recorrection. This is reflected in the headline indices. So there is a growing likelihood that the rate of price falls in this sector will continue to slow over the rest of the year.

Further price falls are likely in the higher loan-to-value and first-time buyer segments of the market, where pricing levels had been stretched by easy access to credit and competition between investors. This might seem at odds with the talk of green shoots. But the green shoots stories are real – it’s just that they are confined to higher-value family housing largely untouched by tighter lending criteria. So there is hope for better times ahead, although the market cannot operate indefinitely on one subset of wealthy active buyers.

The second factor, therefore, is first-time buyers. Only when they feel confident to enter the market in significant numbers can we start to claim any “real” green shoots of recovery.

Most would-be first-time buyers are biding their time in the rental market, where rents are, on average, 10 per cent cheaper than the cost of buying a two-bedroom property. Assuming a 15 per cent deposit is required to buy, then further falls of at least 10 per cent are needed in the price of one and two-bedroom properties before first-time buyers can come back to the market. Even then, buyers will need to feel confident of taking that first step, which may not be until 2010.

The third factor is the rapid contraction in housing market liquidity, which may act as a counterbalance. 2009 is set to be a record low for housing transactions.

With just 675,000 sales forecast, activity could fall to half the level that would constitute a ‘normal’ market. In fact, it is equivalent of the average household moving once every 30 years – compared with once every 16 years, which has been the case over the past decade.

Richard Donnell is director of research at Hometrack, a housing analysis business

Merryn Somerset Webb: The bearish case for property - May 22 2009