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. Last Updated: 07/27/2016

Housing Market Confounds Britain

LONDON -- The British government's bid to tackle the "Achilles heel" of the economy -- the soaring housing market -- is doomed to failure if it enacts new property investment rules in a form signaled this week, analysts warn.

The Treasury issued a consultation paper alongside its annual budget posing questions on the possible structure of new tax-exempt property investment funds aimed at improving market liquidity and transparency for property investors and boosting capital flows into house building.

Analysts said the overly prescriptive tone of the paper, which emphasizes restrictions on borrowing, developments, requirements for the inclusion of housing and more flexible lease and rental contracts, was not attractive to investors.

"The property industry has got a fight on its hands to fend off some of the potential pitfalls of the PIF model," Citigroup analyst Michael Prew said in a research report.

British property shares have rallied over 50 percent since the government indicated it would consider the case for PIFs in last year's budget, outpacing general equities. But the sector, measured by the benchmark European Public Real Estate Association index, pulled back last week as the market digested the budget news on PIFs.

The funds, generally referred to abroad by the U.S. term Real Estate Investment Trusts pay no corporate income tax and zero capital gains tax in return for redistributing most of their income to investors, where the tax liability occurs. The market has been pricing in expectations that PIFs will narrow the discount at which British property shares trade to the value of their underlying real estate holdings or net asset value, or NAV. That discount, largely consisting of taxes, is now just under 20 percent.

As REIT structures were introduced in France last year, French property shares rallied sharply, eroding the discount and eventually moving to a slight premium to NAV. But the French structure is far more flexible and favorable to investors than the one Britain's Treasury seems to be flagging, analysts said.

"There's a lot of government agendas here ... more capital for the economy, lower rents, flexible leases and by implication lower returns and a less attractive investment vehicle -- it's a contradiction in terms," said Adrian Elwood, head of research at Europhypo, Europe's largest real estate financing bank.

Elwood said the government was attempting to structure PIFs to meet its domestic political priorities rather than the hopes of the commercial property sector, particularly record household debt, soaring house prices and the need for more housing supply.

"There is concern the level of debt building up in the property market is destabilizing the economy as a whole. They recognize it's bad for the banks and the property industry as it leads to these debt-magnified crashes," he said.

That is why the government is leaning toward tightly restricting the level of borrowing allowed with PIFs. It wants to offer an alternative balance to the debt-laden property investment options open to private investors now, notably the risky buy-to-let market, he added.

The government is also limiting its potential tax losses from PIFs by applying a conversion charge on unrealized capital gains for companies moving to the new status and narrowly restricting the tax-exempt income allowed to rental income.