A Flight Instructor reported they failed to notice their student descend below 500 feet while practicing engine out procedures.

Narrative

During training maneuver simulated emergency descent; the maneuver started at approximately 3;700 feet with a simulated engine fire; the simulated engine fire was out in the lower 2;000s. The maneuver transitioned to a simulated engine out. During this phase instructor was asking questions and instructing. The student turned for what would be a final for the simulated landing site within a sparsely populated area farm field. At this point high for the simulated landing site; instructor asked how this could be fixed. The student entered a slip first the wrong way then corrected. At that point instructor saw that the airspeed was getting slower than the procedure described. Instructor said to lower the nose for airspeed causing an increase in descent rate then called out go-around. The lowest altitude the instructor saw was mid to high 200s. There was also traffic approaching from the east below 1;000 feet that the instructor was also looking for.During this time the aircraft was passing through 500 feet in which the go-around should have been called. All radio calls were made before and during maneuver. The cause was unexpected increases in descent after the student was slow; as well as the instructor locating other traffic. How to prevent this and correct; there will be verbal communication before the maneuver that recovery will occur at 700 feet no lower as well as the instructor to be more vigilant of altitude as student pilot recovery is not as quick.