TD Economics says it is now expecting a small drop in housing prices next year.

The bank says that its headline forecast for this year remains pretty much unchanged — it still expects 475,000 transactions to take place, with an average annual price nearing $350,000, an increase of 9% over 2009. “However, this hides an underlying shift occurring over the course of this year,” TD says in a new report. “While we anticipated sales and prices to be strong in the first half and to cool in the second half, we now expect this contrast between the two halves will be sharper.”

TD says that first quarter sales came in stronger than expected, but it believes this represents borrowing from future sales as buyers move to avoid new regulatory measures designed to cool the housing market, changes to the tax regime in British Columbia and Ontario, and the prospect of higher interest rates. This means second half results may be weaker than expected.

But, while the overall forecast for 2010 hasn’t changed, TD is altering its forecast for 2011 — it still expects annual sales to decline by 10%-12% next year, but it now sees prices falling next year, too. Originally, it forecast a 1.6% gain in prices for 2011. It now sees a 2.7% drop.

“One crucial factor is the supply-side response (listings) to higher home prices. While it was slow to appear, it is now much stronger than had been expected,” it says. “As a result of the stronger supply response, the market balance is now expected to be somewhat softer next year, consistent with market conditions more favourable to potential buyers and a mild depreciation in home values.”

TD doesn’t see a U.S.-style price correction in the cards, although it does estimate that, “at their peak in the first half of this year, average home prices will be roughly 15% overvalued when benchmarked against long-term economic fundamentals, such as income growth.”

“If our forecast unfolds, roughly a third of this excess would be unwound by year-end 2011, leaving our estimate of valuation at roughly 10% above fundamentals, back to what it was in late 2007,” it says.

“We still expect the bulk of the readjustment to occur over a medium-term time frame of [two to three] years whereby average home prices rise roughly at the rate of inflation — after having climbed by over 8% annually over the last eight years. Meanwhile, household incomes will be allowed to catch up and close the gap, which is concentrated in the country’s most expensive markets (e.g. Toronto, Vancouver),” it concludes.

IE