Why are home prices so high and when will they fall?

A recent report from the Organization for Economic Co-operation and Development that revealed Canada hasthe third most overvalued real estate in the developed world offered few surprises for analysts who say the market is heading for a price correction.

Many say the signs are already evidenthome sales are slumping, demand is down and housing prices will likelyfollow suit. As for when,how far or how hard prices will fall, that still remains a guess.

• Check out our interactive map tracking house prices across Canada

"The housing market is an accident waiting to happen. If there is some sort of macro shock, there'salot of dead air where house prices are now and where historically they should be," said BenRabidoux, creator of the blogEconomic Analyst, which looks into housing and mortgage trends. "And there's a sort of saying thata marketwaiting for an accident to happen usually finds its accident. And that's how I would describe it."

The OECD report used two housing measures the price of the average home compared to what it could be rented for and the home costs compared to the average salary.

The report found that based on rents, Canadian real estate is overvalued by as much as 60 per cent and in terms of prices to incomes,real estate is still as much as 30 per cent overvalued.

"There is no denying we're overshooting, vis-a-vis rent, vis-a-vis income, vis-a-vis demographics. So the OECD is not adding anything here to the debate," Benjamin Tal, CIBC deputy chief economist, told CBC News."That's old news.The interesting question is not that we're overshooting, it's what will be the corrective mechanism, namely what kind of mechanism will we see bringit back to normal."

Availability to credit-fuelled housing market

The reasons forthe high-priced market vary. While low interest rates certainly contributed to thehousing boom, Rabidoux said much has beenfuelled by the availabilityof credit.

"It's not like we haven't seen periods of relatively low interest rates in the past and even in those periods we found thatprices weren't in the extreme like they are today," Rabidoux said. "I think it's very clearit's not so much the interest rate itself, it's that really what we've seen in the last decade has been an unprecedented credit boom. And that's what's really driving these housing prices."

Land constraints and an influx of immigration may have played some role in housing prices in Toronto and Vancouver, butRabidoux said you would have then expected prices to have only been affected in those areas but not others.

"When you look at different metros across the country, you will find [almost] every oneof them has seen a parabolic rise in house prices starting around 2003 without fail. And in my mind the most logical explanation is that this is credit driven."

Thirty years ago, credit was much tighter than it has been in the past decade, Rabidoux said. As early as 2008, someone could walk into a bank and apply for a 40-year-mortgage, fully government insured for zero money down.

Today, while cash back mortgages are still availableand people with a little creativity can still get 100 per cent financing, the government has tightened up the rules, including, most recently, reducing the maximum amortization period for a government-insured mortgage, lowering it from 30 to 25 years.

"Collectively, we are still a lot looser than we were in the past, but that's changing," Rabidoux said.

However Tal of CIBC said government regulations are working to slow down the market.

'Waiting for prices to go down'

"We are seeing resale and sales andsupply anddemand all down. So the only thing we're waiting for is prices to go down. And that will happen."

He believes any adjustment to the market will bea "soft landing" and thatCanada,doesn't andwon'thave thepreconditions of a U.S.-style crash, namely a huge increase in interest rates or the same risky subprimemortgage market.

"I believe we will correct, but thecorrecting mechanism will be a more boring correcting mechanism," he said.

"Maybe prices will go down 10 per cent a year or twoyears from now. Then they will stagnate for a while until the fundamentals catch up."

David Madani, an economist at Capital Markets, said it's difficult to predict when house prices might come down. In the U.S, for example, prices began falling about a year after sales decreased, he said.

"There's usually a lag," he said. "And we're at a point roughly at about a year, because home sales began to decline ... in Canada early last year. So we're at the one-year mark."

Two years ago,his firmpredicted an eventual market correction of about 25 per cent, but he admits that getting the timing right is tricky.

"It's a long-term view. Trying to forecast something like this is almost next to impossible. It's hard enough forecasting other areas of the economy like GDP and interest rates and things like that."

"It's something that's going to play out overa few years. It's not something like the stock market where you'll get these sudden violent movements. Housing markets, when they're booming, they're booming for several years andthen whenthey slow down and slump, they slump for several years."