Despite concerns that the housing recovery is investor-fueled and unsustainable, Capital Economics is confident that market fundamentals are reflective of a long-term, sustainable recovery. At least, that is the research firm's forecast for some states.

According to FHFA data, the average home price rose by 4% in the first three quarters of 2012 alone. In eight states, prices rose more than 7%. Those states include Arizona, California, Washington D.C, Florida, Idaho, Nevada, North Dakota and Utah.

In Washington D.C. and North Dakota, home prices jumped 23% and 18%, respectively. The significant increases reflect the strong incomes and employment of citizens in those states and is aligned with a sustainable recovery.

States such as California, Florida, Idaho and Utah saw more modest price recoveries. However, Capital Economics says they are not concerned because personal incomes and employment have outperformed in those states along with prices.

Arizona and Nevada both saw strong price recovery, 20% and 12% respectively, despite suffering a below average economic recovery.

The employment growth in these states is less than 2% and personal income growth continues to trail the national recovery.

In these states, Capital Economics says they feel less confident in a healthy recovery. Homebuilder confidence in Arizona and Nevada seems to mirror the skepticism of Capital Economics, with the construction activity in these two states at a third of its usual level.

Of the eight states whose home price averages rose by more than 7%, only five of the eight appear to be sustainable, says Capital Economics. Capital Economics believes the valuation in the other states, with the exception of D.C., supports a sustained recovery.

The report says, "Housing in the capital looks to be around 30% overvalued relative to incomes, suggesting that it may now be due a period of underperformance, especially if federal spending cuts take the heat out of the local labor market."

Capital Economics says the level of housing permits nationwide compared to usual levels is a strong indicator that homebuilders are confident in the recovery.

Click the chart below to see which states look to be in full recovery.

John Walsh, president of DataQuick told HousingWire that there are four factors that will play a role in whether or not the housing recovery is sustainable.

We’re in an unsustainably low-interest rate environment, says Walsh. As rates are predicted to inch up in 2013, it is going to create a challenge for potential investors. Walsh added, "Purely from an interest rate perspective, this should be a phenomenal time for people to buy homes."

Tighter lending regulations are making it difficult for new homebuyers to obtain funds, says Walsh. "That’s another thing that’s going to have to happen internally in order to generate purchases from non-investors," Walsh said.

Thirdly, Walsh says California will be important to keep an eye on moving forward. As one of the markets that experienced strong housing activity, it has also seen a very high percentage of investors.

However, with pending tax increases looming, "It’s going to be very interesting to see what impact that has specifically on higher priced homes, which are a significant part of the inventory in California and whether or not people in those income brackets decide it’s worth paying half of their money in taxes or going and living somewhere else."

Regardless of the challenges the recovery will face in the years ahead, time will likely be the determining factor whether the recovery is sustainable or not. Walsh joked with HousingWire that if he were a betting man, he doesn’t know that he’d bet in either direction.

mhopkins@housingwire.com