Sydney and Melbourne house prices are headed for the largest downturn in modern history

• Capital Economics is bearish on Sydney and Melbourne home prices, predicting they'll fall 20% and 17% respectively from the prior cyclical peak.

• It says "this would make the downturn in each city the largest in modern history".

• Don't fret if you live in Australia's remaining capitals, though. The group expects a far more resilient performance from prices.

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In financial markets, a bear market is defined as a fall in an asset price from peak to tough of 20% or more.

If Capital Economics are right, a bear market in Sydney home prices is just around the corner. And Melbourne property prices won't be far behind.

"We estimate that house prices in Sydney will eventually decline by 20% from their peak and by 17% in Melbourne," says Marcel Thieliant and Ben Udy, economists at Capital Economics.

"This would make the downturn in each city the largest in modern history."

So having fallen for over a year, the price downturn in Australia's largest and most expensive housing markets has a long way to go yet in their opinion.

While many point to the impact of tighter mortgage lending standards as the chief factor behind recent price falls, Thieliant and Udy suggest there are other fundamental factors that have and will continue to place downward pressure on values.

"In almost every capital city, the number of houses built in the past five years has outpaced the increase in the number of households," they say.

"That has led to an oversupply of housing and is weighing on prices.

"While supply has started to fall, the imbalance will not be corrected for some time."

And even with recent price declines, Capital Economics says prices in these two cities are still overvalued based on current rental yields.

"We use rental yields to estimate the sustainable house price to earnings (HPE) ratio," says Thieliant and Udy.

"In Sydney, current rental yields imply that house prices would need to fall a further 25% to be consistent with the estimated sustainable HPE ratio, though this is down from a peak of 29%.

"In Melbourne, the gap remains wider than in any other city, implying a fall in house prices of 27% to return prices to a sustainable level."

Helping to explain why Capital Economics doesn't see price falls of the magnitude estimated by rental yields, Thieliant and Udy expect some improvement in rental rates as supply of new housing stock slows.

"A fall in prices isn’t required to bring the HPE ratio to its sustainable level as growth in earnings will help as well," they say.

"We think that some combination of price declines and growth in earnings will eventually bring the HPE ratio to a more sustainable level in each city."

Regardless, price falls of 20% or just less are still large, even when considering that Sydney and Melbourne median values soared in the prior market upswing.

"Arguably, the key reason for the current downturn is that house prices rose too far too fast during the most recent boom in Sydney and Melbourne," says Thieliant and Udy.

However, in contrast to what the pair is forecasting for Sydney and Melbourne home prices, they expect a far more resilient performance from smaller capital city markets, creating the potential for nationwide price measures to bottom by 2021.

"Prices in Adelaide may keep rising while those in Brisbane should remain broadly flat. And prices may soon stop falling in Perth and Darwin," they say.

"On average, prices may be broadly stable across 2019 and 2020 outside of Melbourne and Sydney, giving earnings a chance to catch-up in order to reduce the smaller overvaluations in those cities.

"By 2021, prices at the national level may stop falling."