Home prices in Toronto and Vancouver are going to drop by around 15 per cent over the next two to three years, says a report from TD Bank which also warns that “a severe shock from abroad” could send prices spinning even further.

Economists Derek Burleton and Leslie Preston say that, even though Toronto and Vancouver seem to have diverged as housing markets, with sales and prices falling in Vancouver and still growing in Toronto, the markets aren’t all that different -- and both are headed down in the medium term.

The authors point to what appears to be an oversupply in the condo market.

“Both markets have been driven largely by condo activity, reflecting demographic trends, erosion in affordability of single-family homes, land scarcity due to either geography (Vancouver) or regulations (Toronto),” the report says.

The authors note that over the past decade, 73 per cent of Vancouver’s new housing consisted of condos, rising to 80 per cent in just the last year. In Toronto, it was 63 per cent over the past decade, and 74 per cent over the past year.

But it’s not oversupply that the authors say will push the market down -- rather, it’s shrinking demand. The TD Bank economists expect interest rates to rise, and Canadians to work on reducing their household debt, both of which would put downward pressure on house prices.

And noting the economic headwinds building around the world, the authors caution that “a quicker and more pronounced correction” could occur if Canada suffers a “severe shock from abroad,” a thinly-veiled reference to the European debt crisis.

But they explicitly say they don’t expect the kind of 30-per-cent drop the U.S. experienced after its housing bubble collapsed starting in 2007.

With real estate prices continuing to rise even as the economy shows mixed signs of growth and weakness, many economists are growing alarmed about the state of Canada’s housing market.

In contrast to the TD Bank report, The Economist estimated last fall that Canada’s housing market is overvalued by 29 per cent.

Derek Holt of Scotiabank last month alluded to the “ghost town” phenomenon that occurs when condo bubbles burst, comparing Toronto’s condo market to that of Miami, where a price collapse in recent years makes it possible to buy a condo for $50,000 in some places.

Earlier this year, another TD Bank report called overheated house prices a “clear and present danger” to Canada’s economy.

Fitch ratings agency reported last month that a 10-per-cent reduction in the value of mortgages would erase some $91 billion from banks’ balance sheets -- a large amount, but not necessarily rising to the level of a crisis.

But not everyone is quite as pessimistic about the future of Canada's housing market. Credit union Capital1 forecasts that Toronto house prices will continue to rise for two more years, while credit ratings agency DBRS says Canadians on the whole could withstand a house price drop of as much as 40 per cent.

Loading Slideshow...
  • St. John's, Nfld. -- $125 Per Square Foot

    This four-bedroom, two-bathroom custom-built bungalow in St. John's West End neighbourhood boasts hardwood floors, a covered sundeck and an oversized yard. With an asking price of $349,900 and 2,750 square feet of livable space, this spacious home costs approximately $125 per square foot.

  • Trois Rivieres, Que. -- $127 Per Square Foot

    This five-bedroom, two-and-a-half bathroom house features a double-width garage and a heated inground pool. At approximately 2,750 square feet and an asking price of $349,900, it works out to around $127 per square foot.

  • Winnipeg -- $160 Per Square Foot

    This spacious split-level home in southeast Winnipeg features four bedrooms and three baths, a stone fireplace and a jazuzzi in the master bedroom. It sits on a 142-foot-long, pie-shaped lot. At 2,182 square feet and a $349,900 asking price, it works out to around $160 per square foot. <strong>CORRECTION:</strong> <em>An earlier version of this slide incorrectly listed the price-per-square foot as $600</em>.

  • Red Deer, Alta. -- $248 Per Square Foot

    This five-bedroom, three-bath home features vaulted ceilings, a fireplace and a massive walk-in closet in the master bedroom. At 1,408 square feet -- this average-sized house on the prairie works out to $248 per square foot.

  • Montreal -- $250 Per Square Foot

    This two-story townhouse condo just east of downtown Montreal features three bedrooms and two baths, cherry wood floors and a terrace. At 1,400 square feet and an asking price of $349,000, this condo works out to $250 per square foot.

  • Burlington, Ont. -- $388 Per Square Foot

    This cozy bungalow on the edges of the Greater Toronto Area features four bedrooms, two baths and a long, 175-foot lot. Highlights include a granite countertop and newly finished hardwood floors. At a snug 900 square feet, this house is going for $388 per square foot.

  • Toronto -- $499 Per Square Foot

    This one-bedroom, one-bath condo in Toronto's Entertainment District features a balcony with a southeast exposure. In a sure sign the condo is outfitted with just the basics, the unit's sellers boast of its "brand name appliances" and "frost free refrigerator." At 700 square feet (including the balcony), it works out to $499 per square foot.

  • Vancouver -- $688 Per Square Foot

    This one-bedroom, one-bathroom corner unit in Vancouver's Kitsilano neighbourhood "shows much larger than the square footage," the realtor boasts. That's good, because at 508 square feet, this place is only slightly larger than some of the bedrooms and living rooms available in similarly-priced houses in other markets. The condo boasts "gorgeous mountain views," but it'll cost you -- $688 per square foot.