Nov. 9 (Bloomberg) -- U.K. house prices may fall next year as a ``toxic mix'' of higher interest rates, overvaluation and record debt deters property investors, Citigroup Inc. said.

``We suspect that the number of buy-to-let home purchases will fall outright in 2008, hence contributing to a sharp drop in overall housing turnover'' and a price decline of between 1 percent and 2 percent, said Michael Saunders, chief western European economist at Citigroup, in an e-mailed note. ``There is a sizeable risk that the outturn will be worse.''

The U.K.'s housing boom has been driven in recent years by so-called buy-to-let investors, who purchase properties to rent them to tenants, Citigroup says. With rental yields declining and buy-to-let mortgage lenders finding it more expensive to raise funding in the money markets, house prices may lose that prop.

The number of new buy-to-let mortgages, which have more than doubled since 2002, may drop 45 percent in 2008, Citigroup says. Loans for first-time buyers have dropped 31 percent in the past five years and may be little changed next year, the bank said.

Britons are shouldering a record 1.4 trillion pounds ($2.9 trillion) in debt and trying to cope with five interest-rate increases in a year from the Bank of England. The U.S. subprime mortgage slump has also pushed mortgage rates higher, further hurting affordability.

Capital Gains

Citigroup said house prices may also fall as the government's decision to cut capital gains tax encourages owners to sell. The new levy came into effect in April and will lower the tax on second-home sales to 18 percent from as much as 40 percent.

``Buy-to-let investors may be tempted to sell soon in case the government, as it often does, reverses the tax change in a year or two,'' said Saunders.

U.K. house prices, which have tripled in the past decade, are already showing signs of falling. Values dropped for a second month in October, the first back-to-back decline since May 2005, mortgage lender HBOS Plc said yesterday.

Higher prices have made it harder for investors to profit from letting out their properties. Rental yields on houses and apartments are now about 5 percent, says Citigroup, which compares with the 6.37 percent average rate offered by lenders this month on a two-year mortgage for 95 percent of the property price.

Housing weakness will probably lead to a ``sharp'' slowdown in consumer spending, prompting the Bank of England to cut rates, said Saunders. He expects the bank to reduce its benchmark rate by 50 basis points from 5.75 percent.

``Given weakness in housing and financial market strains, risks lie on the side of more, rather than less, easing,'' said Saunders.

To contact the reporter on this story: John Fraher in London at jfraher@bloomberg.net

Last Updated: November 9, 2007 12:05 EST