Prices surged 123 per cent between 2002 and 2010, prompting the state to take steps to help speed up construction in response to forecasts for higher demand in the city. As developers responded, increasing the number of housing units 41 per cent from 2008 to 2011, population growth slowed. That created the nation's most over-supplied housing market.

About 160,000 permits were granted to build houses and apartments in Melbourne in the four years to June 30, compared with 80,918 in Sydney, Australia's biggest city, and 613,837 across the nation.

"New construction will keep a lid on any major recovery" in Melbourne, said Louis Christopher, managing director of Sydney-based property advisory firm SQM Research. "There are also a lot of foreign investors in the marketplace. This makes it potentially volatile, and, if they want to get out, it could be problematic."

Far East Consortium, based in Hong Kong, is developing a 2,600-apartment complex in the city centre. Malaysia's SP Setia is building almost 800 apartments in two towers.

SP Setia sold 70 per cent of the first building in Malaysia and about half of the second tower to buyers in Malaysia, Singapore, China and elsewhere in Asia, Choong Kai Wai, the company's Australian chief executive officer, said. It will begin marketing a second development in South Yarra, a riverside suburb, this year, targeting mostly local buyers.

"I don't think there's an oversupply because the rental market is still good," Choong said. "The reservation is the price point. Anything above A$600,000 (HK$4.8 million) has a bit of resistance."

Melbourne's rental vacancy rate was 2.9 per cent in July, up from 2.5 per cent a year ago. The number of homes listed for sale climbed 4.8 per cent from a year earlier to 48,322 as demand slowed.

Victoria's moves to do away with tight land-release policies and zoning restrictions had won praise in a nation where such controls are blamed for a housing shortage that's driving home prices beyond the reach of ordinary workers.

The measures have helped lift Melbourne, known as Australia's cultural capital for its art festivals and stage performances, to the top of the Economist Intelligence Unit's Global Liveability Survey this year.

Even after recent declines, Melbourne - with its historic tram network and cafe culture - remains the priciest city in Australia compared with long-term averages, according to Morgan Stanley.

The median price of a home in greater Melbourne was US$493,688 as of July 31, according to RP Data, based on the exchange rate on that day. That compares with US$340,600 in New York and US$564,593 as of June 30 in London.

"With significant spikes in dwellings under construction and dwellings on market, weaker population growth and now the lowest relative affordability of all markets, we expect pricing pressure in Victoria will continue for some time," Morgan Stanley analysts wrote in a July 23 report.

Relative to incomes, Melbourne had the fourth-most unaffordable homes among metropolitan areas with populations of more than 1.5 million in the developed world, consultancy Demographia said, behind Hong Kong, Vancouver and Sydney. Melbourne's median home price is 8.4 times median household income, compared with 6.9 times in London, 6.2 times in New York and 5.5 times in Toronto.

The Housing Industry Association-Commonwealth Bank Housing Affordability Index for Melbourne rose 7.3 per cent in the first quarter, partly driven by falling land prices.

Greater Melbourne's population growth slowed from 2.4 per cent in the year ended June 2009 to 2 per cent the following year and 1.6 per cent the next.

Despite the concerns about a glut, "it's too early to conclude that Victoria's planning policy failed or created a massive oversupply problem", Matthew Hassan, Sydney-based senior economist at Westpac bank said. "We expect a few moves downward from the Reserve Bank next year, which will bolster a very patchy stabilisation process."

The Reserve Bank of Australia has reduced the overnight cash rate by 1.25 percentage points since November to 3.5 per cent, partly in response to a stalling housing market, as the lack of affordable homes and economic uncertainty kept buyers on the sidelines. The rate cuts, as well as rising rental yields, had probably increased the attractiveness of investing in housing, the central bank said in minutes of its August 7 board meeting.

Along with SP Setia and Far East Consortium, local groups are also building major housing and apartment projects. The Industry Superannuation Property Trust, an Australian direct property investment manager owned by pension funds, is planning a complex with six buildings containing 2,900 apartments, and listed trust Mirvac Group's projects include Yarra's Edge, a five-tower neighbourhood that includes luxury apartments and homes in the city's Docklands.

"We're in a period in the short term where we have seen some signs of oversupply," Brett Draffen, chief executive officer of Mirvac's development division, said. "But underlying fundamentals will be strong for the medium term and beyond, and that's when those projects come online."

The number of unoccupied homes further exacerbates the issue, according to tax-reform advocacy group Prosper Australia. About 246,700, or 11.3 per cent, of homes across Victoria were unoccupied, data from the 2011 Census showed.

Melbourne alone has about 90,730 empty houses, according to a report by Earthsharing Australia, a subsidiary of Prosper, based on the number of homes that used less than 50 litres of water a day between July and December.

"There's a profound oversupply in both apartments in the city and in the outer suburbs," said David Collyer, campaign manager at Prosper. "We're not seeing anything like the demand response needed to sustain a recovery. The market has nowhere to go but down."