Canada's housing market is in a bubble that's set to burst and prices could plunge by as much as 25 per cent, a major independent research firm warns.

"Housing valuations have lost all touch with fundamentals and household debt is at a record high," economists at the research consultancy Capital Economics say in their most recent Canada Economic Outlook, issued Wednesday.

"Our fear is that, with the housing bubble now close to bursting and commodity prices retreating, Canada will go from leader to laggard."

The report predicts a fall in house prices by as much as 25 per cent over the next three years.

A domestic housing boom coupled with high commodity prices worldwide have spared the economy the severe recession felt by other developed countries.

'Housing valuations have lost all touch with fundamentals.'—Capital Economics

Canada’s economic success could become the thorn in its side as the threat of a downturn in the housing sector looms, the report says.

The firm says a burst housing bubble would shrink real estate investment and hurt consumption — two things that would considerably slow economic growth.

This decline in consumption would mean a slowly rising unemployment rate as well, according to Capital.

The company says Canadian house prices are overvalued by approximately 25 per cent, close to excessive levels seen in the frothy U.S. market at its 2006 peak.

Over-building is already visible; the number of unoccupied houses and condos is at a record high. It closely resembles the 1994-95 housing slump, when the construction industry experienced a severe downturn.

The report forecasts falling house prices and smaller residential investment. Real estate currently makes up 6.8 per cent of Canada’s GDP. Lower prices would mean a hit to household net worth as property now accounts for one-third of a family’s total assets, the report found.

The firm expects the Bank of Canada to stay the course in the near term, as financial worries at home and abroad will keep interest rates at their current level for a while.