After several years of apparently unstoppable gains — particularly in Toronto and Vancouver — most economists are predicting that the Canadian housing market will enter a cooling phase in the second half of this year.

But while the frothiness of residential real estate is set to ease off, a sharp drop in prices is not widely expected. There is, however, a small group of analysts who believe that rising interest rates could precipitate a 20% drop in housing prices.

Complicating the outlook is the rising lack of affordability of homes. Based on average Canadian household incomes, analysts estimate that Canadian house prices are overvalued by 15%-35%. That is, Canadians are currently short by 15%- 35% of the amount needed to comfortably afford to buy a house or service the mortgage.

If mortgage rates rise, as everyone expects them to do, affordability will deteriorate further unless the rise is accompanied by increases in household income and/or declines in house prices.

The range of overvaluation remains an estimate. If the actual figure is at the low end of the range, at 15%, and household incomes grow at a healthy pace while interest rates rise only gradually at the same time, house prices may hold steady. But if the overvaluation is 20% or more, there could be a sharp correction in house prices, as more buyers leave the market due to difficulty carrying their mortgages when interest rates climb.

When it comes to predictions, the largest number of analysts fall into the group calling for modest house price declines. Pascal Gauthier, an economist with Toronto-Dominion Bank in Toronto, has pegged the expected decline of average national house prices at about 6% by the end of 2011, relative to the peak set during the second quarter of this year. If household incomes rise by about 2.5% both this year and in 2011, the rate of overvaluation will decline to around 5% at the end of 2010. Gauthier expects that further household income gains in 2012 and 2013 will eliminate the over-valuation rate.

Both Gerry Solloway, chairman of Home Capital Group Ltd. in Toronto, and Will Dunning, chief economist at the Toronto-based Canadian As-sociation of Accredited Mortgage Professionals, agree that there could be a drop of around 5% in house prices over the next 18 months.

However, Marc Pinsonneault, senior economist with National Bank Financial Ltd. in Montreal, and Jimmy Jean, economist at Moody’s Investors Service Inc. in West Chester, Pa., are more optimistic, with neither expecting any drop in Canadian house prices.

All four experts note that there were particular reasons for the strong run-up in house prices over the past year. The 2008-09 recession had caused prices to cool as buyers left the market. Having returned in force and spurred on by historically low interest rates, some current buyers represent pent-up demand.

Some purchasers in Ontario and British Columbia are also hurrying into the market to avoid higher sales taxes when those provinces switch to the HST in July.

There is, however, a minority camp that views the current situation as a housing bubble that is due to burst in the next year. A leading proponent of this view is David Rosenberg, a Canadian who was formerly chief economist with Merrill Lynch & Co. Inc. in New York and is now chief economist and strategist at Toronto-based Gluskin Sheff & Associates Inc. in Toronto. He likens the current Canadian housing market to the overheated situation in the U.S. in 2005 and he thinks there could be a drop in prices of as much as 20% over the next 18 months.

Rosenberg’s argument is that the housing market — at least, in Vancouver and Toronto — is so bubbly that it has become rather nutty. “Everyone is caught up in the moment,” he says. The inevitable reaction to this state of affairs, he adds, is that as interest rates rise, there will be a “precipitous fall in prices” — and not just to fair market levels but probably further down, as usually happens. However, he says, areas of the country outside of the Greater Toronto Area and B.C.’s Lower Mainland will not be as affected by the bubble’s dynamics.

@page_break@Other economists also agree that a sharp correction is possible if consumers start to believe there’s a bubble and suddenly withdraw from the market, although they do not think that event is likely.

Measurement of housing price increases are difficult because it usually involves comparing apples and oranges. Most measures use the average prices of houses sold in a particular period vs the same period a year earlier. But some of the differences in average prices can be due to changes in the types of homes being sold. For instance, a larger number of luxury homes may be bought or sold vs the same period a year earlier.

NBF has developed a metric called the Teranet-National Bank composite house price index that avoids this problem by using prices in the two periods only when they are for similar homes. In February 2010, this index showed a 9.9% increase nationally from a year earlier — much lower than the 18.2% suggested by average prices from the Canadian Real Estate Association.

There was a particularly dramatic difference for Vancouver’s numbers, with the Teranet-National Bank index at 11.8% vs 29.7% for the CREA. Toronto was 13.3% vs 19.4%; Calgary was 2.2% vs 8.3%.

The Teranet-National Bank index is not widely known, however, so CREA’s prices are the ones most often quoted.

A sharp rise in mortgage rates could cause a plunge in house prices, but, again, most economists don’t expect that to happen. While Canadian economic growth was healthy in the fourth quarter of 2009 and in the first quarter of this year, the pace is expected to slow later this year. As a result, most economists expect that the Bank of Canada will increase interest rates only modestly.

The five-year mortgage rate has already moved up to 6.1%, but prime remains at 2.25%. Increases are expected in both rates, but the big move will be in the prime rate, which could go up by 100 basis points this year and by another 100 to 150 bps in 2011.

The good news is that only about 25% of Canadians have variable-rate mortgages, and approval for such mortgages is based on the borrower’s ability to service a three-year, fixed-rate mortgage, which has not been below 4.15% in the past few years. Thus, variable-rate mortgageholders have room in their budgets for higher mortgage payments.

Another danger is that there could be a surge in speculative buying. However, new regulations from Canada Mortgage and Housing Corp., which insures most mortgages, have increased the down payment requirement for mortgages on residential property being purchased for investment purposes dramatically, to 20% from 5%.

Economists do, though, warn that the housing market is unlikely to be as buoyant in the next five years as it was in the five years leading up to the 2008-09 recession.

“It is time for Canadians to reset their housing market expectations,” says Adrienne Warren, senior economist with Toronto-based Bank of Nova Scotia in a March report. She expects that 2010 will be a transition year, which will give way to a “sustained period of more subdued housing activity over the coming decade.”

Warren expects slower economic growth in Canada, which is likely to mean slower household income growth.

As well, Warren expects a slowing in total household formation, which had been increasing at a fast pace due to the rapid rise in one-person households. She believes that trend has now stabilized. IE