April 17 (Bloomberg) -- Richard Lee spent 5.3 million pounds ($10 million) buying 20 rental homes across the U.K. with just 150,000 pounds of his own money. Today, the properties are worth about 60 percent less and owned by the banks that financed the purchases.

Lee was one of thousands enticed by one of Europe's top five best-performing residential property markets during the past decade. Now repossessions are mounting and properties stand empty as many investors fail to find the tenants needed to cover their mortgages after a building boom flooded cities, especially Leeds and Manchester, with apartments.

The unraveling buy-to-rent investment market contributed to a 2.5 percent drop in home prices last month, the biggest since 1992, a report by mortgage lender HBOS Plc shows. Britain is among the countries most likely to follow the U.S. into a housing slump, according to the International Monetary Fund. Prices may drop 10 percent this year and next, said Michael Saunders, a London-based economist at Citigroup Inc.

``Buy-to-let investment was a bubble inside the housing market bubble,'' Saunders said. ``It's turning out worse than I thought.''

Home purchases by investors such as Lee helped triple housing prices between 1997 and 2007. The buy-to-rent market in the U.K. increased 19-fold to about 190 billion pounds in the same period, according to London-based broker Savills Plc.

Tax Incentive

Banks started promoting buy-to-let mortgages in the mid- 1990s, after the government ended rent controls and introduced fixed-term leases to ensure that tenants vacated properties. Interest payments on the loans are tax-deductible, making them attractive for landlords.

Rental properties generated annual investment returns of about 22 percent in the five years ended March 31, according to the Association of Residential Letting Agents in Warwick, England. The U.K. FTSE All-Share Index climbed about 12 percent, including reinvested dividends.

The ``virtuous circle'' of rental investment that powered the U.K. housing market was broken by falling property values and banks' retrenchment following record mortgage-related losses, Saunders said. Banks and securities firms have disclosed about $245 billion of asset writedowns and credit losses since the beginning of 2007.

The number of available buy-to-let mortgages dwindled to 926 in the first week of April from 3,362 at the start of August 2007, according to personal finance Web site Moneyfacts. Average two- year fixed-rate mortgage rates have climbed to 6.5 percent, or 1.5 percentage points more than the gross rental yield from a property in the first quarter.

Vulnerable Investors

Investors such as Lee, who have high levels of debt, and homebuilders that focused on developments in the center of English cities such as Leeds and Manchester are now the most vulnerable to the deflating buy-to-let market.

Buy-to-let investors who were behind on their mortgages by three months or more increased by 25 percent to 7,584 in the fourth quarter, according to the London-based Council of Mortgage Lenders. Repossessions rose 26 percent to 1,247.

Connells Asset Management in Leighton Buzzard, England, which sold more than 10,000 repossessed homes last year, expects the number of foreclosures to rise from the 20 percent gain already reported, led by cities in the northern part of the country.

High-Rise Condos

The skyline of central Leeds is dominated by construction cranes erecting high-rise condominiums, 60 percent of which were sold before completion to buy-to-let investors, according to London-based real estate broker CB Richard Ellis Hamptons International.

``Leeds is where we are seeing more city-center apartments coming onto our books,'' said Managing Director Mike Pudney.

Thousands more apartments are being built in the center of the city, where two-bedroom homes lost 12 percent of their value in the past two years, according to London-based research firm Hometrack Ltd. Brokers report average rents for these properties have dropped by about 20 percent and about 13 percent of city- center apartments are empty, according to Leeds City Council estimates, based on local tax returns.

``Twelve months ago, development was an easy way to make your fortune,'' said Tom Bloxham, chairman of Manchester-based Urban Splash, which develops derelict sites. ``Today, it's a disaster zone.''

`Mini-Floridas'

City center condominium developments like what's happening in Leeds represent Britain's ``mini-Floridas,'' said Alastair Stewart, who tracks homebuilders at Dresdner Kleinwort Securities in London. The state of Florida had the third-highest foreclosure rate in the U.S. in March, with one foreclosure for every 282 households, according to RealtyTrac Inc., the Irvine, California- based seller of data on mortgage defaults.

In Leeds, the market got so bad that a unit of Taylor Wimpey Plc, the U.K.'s largest homebuilder, delayed the planned 800-unit Green Bank condominium project in November. It may seek a zoning change to allow a mixed development of offices, shops and apartments. Taylor Wimpey dropped 40 percent in the past six months in London trading on concern about the collapse of the buy- to-let market and the slide in land values and home prices.

Barratt Developments Plc, Bellway Plc, Bovis Homes Group Plc, Berkeley Group Holdings Plc, Persimmon Plc and Redrow Plc declined by 16 percent to 48 percent in the same period.

Investment Clubs

Newly built apartments accounted for a ``significant part'' of the investments made by 61 percent of new buy-to-let investors over the past six years, Savills reported. Many of those purchases were brokered by the dozens of Internet-based property investment clubs that sprang up since 2000.

The clubs often attracted novice buyers, some of whom lacked ``an understanding of the risks that such investments pose,'' according to U.K. regulators at the Financial Services Authority. In May 2005, the government forced two of the clubs into liquidation to protect investors.

For a fee, the clubs offer members residential developments before construction work begins. They negotiate a price with homebuilders that is below the valuation made by an appraiser, and collect a percentage of the purchase price as a fee. The clubs also offer their dues-paying members property management, home insurance, legal and mortgage-broking services.

City Gate 2

Lee, 37, bought an apartment in the City Gate 2 development in Manchester for 239,500 pounds in October 2005. An identical property in the same building sold for 115,000 pounds earlier this year, said Lee, who has surrendered his keys to the bank.

Lee also purchased 17 properties, most of them in Leeds, in late 2005. He said he expected to earn a steady income from renting to students.

After the transactions were completed, Lee said he realized he had overpaid for the properties. He said 15 hadn't been refurbished as promised, the tenants occupying the homes had left and rental-income projections were wildly optimistic.

``The valuations were 15 years ahead of their time,'' Lee said. ``The biggest genius in the world couldn't have got those loans to work.''

Lee estimates his properties are worth about 3 million pounds less than he paid for them. The banks will probably ask Lee to repay the money when the homes, now in their possession, are sold. He doesn't have the money, he said.

Legal Action

Lee and 85 other investors plan to sue the developers, lenders, appraisers and solicitors involved in their property transactions. Lee's attorney, Hammad Ahmad of Max Gold Partnership in Hull, England, said the lawsuit will probably be filed in about two months.

Regulators and the government are beginning to review the practices and excesses of the U.K.'s housing boom. The FSA said in its 2008 report on financial risks that ``organized property fraud is most common in new-build and purpose-built flats in major towns and cities, and where renting is the main form of tenure.''

The FSA is probing more than 200 cases of suspected mortgage fraud and the City of London Police department is recruiting for its economic crime department to investigate fraud nationally.

Chancellor of the Exchequer Alistair Darling last week appointed James Crosby, former chief executive officer of HBOS, to make recommendations on improving the U.K.'s mortgage market.

Tony McKay, chief operating officer of Instant Access Group, the country's largest property investment club, said it's time the U.K. started regulating companies such as his.

``It's really strange,'' he said in an interview. ``A pension-provider is regulated for taking in just 20 pounds a month.''

Many homeowners and tenants have profited from the buy-to-let boom, said Michael Ball, professor of urban and property economics at Reading University, 35 miles west of London. And even as home prices decline, most investors will hold onto their properties, according to a Savills survey.

Once he has dug himself out of his current financial difficulties, Lee will consider getting back into the business.

``Would I do buy-to-let again?'' he said. ``Without a shadow of a doubt. This time I'll ensure I'm in control of all the levers.''

To contact the reporter on this story: Simon Packard in London at packard@bloomberg.net.

Last Updated: April 16, 2008 19:00 EDT