The increasing likelihood of cuts to interest rates, perhaps even as early as next month, may not be enough to turn the property market around.

Australian Property Monitors house price data for the June quarter show falls of 2.1 per cent in Sydney and 0.6 per cent in Melbourne.

House prices are likely to come under further pressure as the combined effect of official rate rises and increases by lenders bites.

"The Australian property market has defied gravity for a long time and I think that gravity is now starting to get the upper hand and we are starting to see prices come down," says Shane Oliver, the chief economist at AMP Capital Investors.

The Reserve Bank has increased rates to 7.25 per cent, a 12-year high, to slow the economy and keep inflation in check.

Lenders have also added about 0.5 percentage points on top of this to their mortgage rates. They say they have had to do this because of higher borrowing costs as a result of the global credit crunch. Most standard variable mortgage rates are now above 9 per cent.

Lower auction clearance rates and lower sales turnover also point to continued weakness in the housing sector.

Approvals to build new homes are down by almost 8 per cent nationally in the year to June, although there were big variations between the states.

Australia has a shortage of up to 40,000 homes - as a result of fewer houses being built and a growing population driven by record migration levels - which led many economists to expect house prices to hold steady. However, high borrowing costs are outweighing the positives.

Rising rents are not sufficient to entice investors back into the property market.

Australian Property Monitors data show "asking" rents for Sydney houses increased 8 per cent in the June quarter to a weekly median of $420 - the highest of any capital city.

For the year to June, rents for Sydney and Darwin houses rose 15 per cent, and in Melbourne and Perth rents rose 17 per cent.

Property investors tend to favour units over houses and the rental growth for units has not been as strong as for houses. Rents for Sydney units in the June quarter were 4 per cent higher and 11 per cent higher for the year to June. Rents for units in Melbourne were 3 per cent higher in the June quarter and 13 per cent higher for the year.

Louis Christopher, the founder of SQM Research, says the "rental crisis", particularly in Sydney, is easing but it is still "tight" at the cheaper end of the market, with a similar pattern in Melbourne.

Christopher says the national rate for city vacancies was 2.9 per cent in June; the Sydney figure was 3.6 per cent and Melbourne 2.6 per cent. Vacancy rates of about 3 per cent are regarded as indicating a balanced market, where rents rise in line with inflation.

Despite a reasonable supply of rental property in Australia's two biggest cities, rising rents and rising yields for property investors, the increasing cost of borrowing has reduced purchasing power.

Christopher expects property prices in Sydney and Melbourne will be "flat" over the rest of the year. However, he says, the full effect of the credit crunch will be felt next year.

If interest rates remain steady until Christmas, Christopher says Sydney and Melbourne house prices could fall by between 10 and 15 per cent in 2009.

He says the falls will not be as great if the Reserve Bank cuts interest rates. The economy is slowing, inflation is lower and the market is now factoring in a September rate cut.

But a single cut is unlikely to make much difference to property markets, as mortgage rates will still be high and, in any case, lenders may not hand on the entire cut to borrowers.

Some economists, however, think there could be two or three rate cuts next year.

Scott Haslem, the Australasian chief economist at UBS, is "mildly optimistic" that the combination of flat or modestly lower house prices, higher rents and falling interest rates will encourage property investors into the market, which should help create a floor for house prices.

Savanth Sebastian, an equities economist at Commonwealth Securities, sees a silver lining in the doom and gloom. "Demand is outweighing supply, by far, and you have migration growing at the fastest level in 18 years," he says.

He is forecasting rents to rise nationally by 10 per cent during this financial year. He thinks house prices will start to rise in response to the Reserve Bank cutting rates or even if the bank makes it clear to the market that rates are going to stay on hold.

Angie Zigomanis, a research analyst at BIS Shrapnel, says there may be "scope for more falls [in house prices] over the next six months" but he is "more positive" about next year. If interest rates were to come down, that could be a "ray of sunshine" particularly in Sydney where owner-occupiers and investors have been "battered so much and that might get them coming back into the market".

He says even if rates do fall they are unlikely to come down by much and houses will still to be unaffordable for many.

Zigomanis says eventually people are going to have to adjust their expectations. "They may have to consider an apartment rather than a house or moving two or three suburbs out from where they ideally would like to buy," he says.