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Homes for sale in MontrealChristinne Muschi

Higher interest rates could "easily" cause Canadian home prices to collapse, Capital Economics warned in a bleak report that suggests the housing market is likely to suffer the same sort of crash that has plagued countries such as the United States.

The report suggests that house prices in Canada have climbed at the same pace as the United States, but have not fallen at the same rate. In the United States, some markets have seen prices fall as much as 50 per cent through the recession.

As the Bank of Canada raises interest rates, mortgages will become more expensive for consumers. Add inflation to the mix, and Capital Economics predicts prices could fall 25 per cent over the "next few years."

"Even small rises in official interest rates have been shown to have a big effect on homeowner confidence in other countries under similar circumstances as they can change perceptions toward the housing market very quickly," Capital Economics economist David Madani said. "If the Bank of Canada does resume its monetary tightening this year, this could easily prove to be a tipping point for a house price collapse."

Other market watchers expect higher rates to hinder price gains, but few are calling for as sharp a drop. The Canadian Real Estate Association expects sales to fall 9 per cent this year, for example, but prices are only expected to drop 1.3 per cent. It hasn't issued a forecast beyond 2011.

Bank of Nova Scotia economist Adrienne Warren said it's difficult to compare the Canadian situation with the American because Canada's gains have been based on a strong economy - relatively speaking - as opposed to easy lending.

"We lack the triggers that prompted the U.S. market to crash," she said. "I think what you see is prices staying flat as incomes rise over the next few years."

Such a scenario could lead to home prices that are flat over the next five years, as personal incomes catch up.

"I think some markets may be overvalued and they can't stay that way forever," she said. "If you look at the longer-term trend in ratios, we could say things are overvalued by about 10 per cent, which is typical at the end of a boom. But there are so many different measures - it's just safe to say that eventually you see a softening in prices."

The country's bank economists have varied short-term forecasts, but there are no expectations among the largest forecasters that a crash is inevitable, or even likely.

Some have suggested drops of 10 per cent may be in order next year as mortgage rates move higher and households struggle to service record debt loads, and the Bank of Canada specifically mentioned the prospect of "a more pronounced correction in the Canadian housing market" as one of three key risks to the country's economy.

However, real estate sales data from the autumn market showed that fewer houses have been listed and prices were largely unchanged from a year ago.

Capital Economics chief concern is that as the central bank raises rates, variable-rate mortgages become more expensive and homeowners could find themselves priced out of their homes.

Fixed-rate mortgages are tied to government bond yields, but would move in the same general direction. If a homeowner is already stretched financially, any hike could prove problematic.

However, a survey by the Canadian Association of Mortgage Professionals released late last year showed that Canadians are confident they could shoulder higher mortgage payments without too much difficulty, with 84 per cent saying a $300 monthly increase was no problem.

If prices do fall as far as Mr. Madani predicts, "the knock-on effects to consumer spending and housing investment could be significant and perhaps even strong enough to push the economy into another recession," he said.

Capital Economics also warns that a crash in prices could cost Canada Mortgage and Housing Corp., which insures high loan-to-value mortgages, a loss of as much as $10-billion.

In January, the federal government shortened the maximum amortization period for mortgages to 30 years from 35 to rein in Canadians from taking on more debt at a time when it is at record highs.

While most private sector watchers expect the market to pull back in the second half of this year after a strong two-year run, the Capital Economics call for a 25-per-cent drop is the harshest.

After hitting record highs in May, the Canadian market did slow down, and ground to a halt across most of the country through the summer. Recent data from the Canadian Real Estate Association has many economists predicting a "soft landing," however, with activity returning at a lower level and prices holding steady rather than rocketing higher each month as they have through the recovery.

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