* Hollande's target for 500,000 new houses still out of reach
* Housing investment slumped 2.6 pct in the first quarter
* Red-tape, prices put off buyers despite strong demand
PARIS, May 28 (Reuters) - Strangled by regulation and high prices, weak French housing investment is proving a major drag on the euro zone's second-biggest economy as it struggles to stage a convincing recovery.
President Francois Hollande pledged more than a year ago to slash red tape holding back construction, hoping to bring within reach an oft-repeated promise to build 500,000 new homes a year.
But property developers complain that government measures since then have even discouraged home building and say they simply cannot make houses at prices would-be buyers can afford.
There's no shortage of demand: Charity Fondation Abbe Pierre estimates that some 3.5 million people in France are without a roof of their own or inadequately housed.
According to statistics agency INSEE, household investment - primarily in real estate - slumped 2.6 percent in the first quarter from the previous three months. That was the biggest drop since the 2008 financial crisis and brought household investment to its lowest since mid-1999.
"Falling household investment is really starting to weigh on growth," said Francois Payelle, head of the French Property Developers Federation. "What was a marginal subject has now become sensitive in macroeconomic terms."
With the government counting on economic growth this year of 1 percent, any slack in housing investment puts an added onus on companies and consumer spending to keep the recovery on track.
Developers put about 350,000 properties on the market last year, far below Hollande's target and extending the list of unfulfilled promises by the Socialist president, whose poll ratings are mired at record lows for a modern-day French leader.
No meaningful pick-up is expected this year after a soft first quarter. "Given the demand, we should be able to put a lot more houses on the market, but we can't," said Payelle.
For him, new housing regulations that recently took effect have made a bad situation worse, with additional restrictions on rents and other rules putting off would-be investors and buyers.
A new law that allowing government officials to set rent limits in cities of over 50,000 people has spooked investors, who fear lower rents will make their properties unprofitable.
Developers also say local authority rules on parking places, apartment sizes and how many floors buildings may have also stop them being able to build the properties people want or need.
SUPPLY AND DEMAND
A 30 percent jump in prices over the last decade has made home ownership impossible for many even though the market has cooled over the last two years. Prices fell 1.4 percent in the first quarter compared with a year before, data from INSEE show.
Figures from the OECD suggest prices relative to household income are now less affordable in France than in Britain, where the central bank has warned of a potential housing bubble.
The government acknowledges that building norms need to be eased. New Housing Minister Sylvie Pinel has promised to deliver a list of 50 measures next month to cut red tape.
"Boosting supply is a way of reacting to the housing crisis that many French people are living, encouraging lower prices and breathing new life into the building sector," Pinel said.
With housing starts down 17.6 percent in the three months to end-April from a year ago, the situation has become urgent, the Housing Ministry said on Tuesday.
"It's worrying. It's a sector that's missing out on the recovery," said IMF mission chief to France Edward Gardner, adding that prices remained too high to encourage investment.
The building slump contributes to French unemployment stuck above 10 percent. Some 122,500 construction jobs - 8 percent of the workforce - have been shed since the financial crisis.
Developments in the French housing market also influence shares in real estate developers like Nexity, Kaufman & Broad and construction groups Bouygues, Vinci and Eiffag.
Bank of France Governor Christian Noyer has pointed out that housebuilding is falling short even though France ploughs more public money into the sector than any other developed country through a range of measures to encourage home ownership.
"It's a valid question whether these policies have only led to higher prices rather than construction," said Gardner.
Record low interest rates as the euro zone struggles to recover from its debt crisis - caused in some countries by the popping of huge property bubbles - have helped keep mortgage lending buoyant, although March saw a small decline.
French banks usually refuse mortgages that will saddle a borrower with monthly payments greater than a third of their income, a policy Noyer says has kept default rates manageable.
Longer-dated mortgages have allowed French households to borrow more, although most have lower debt than in countries such as Britain. Bank of France data shows household debt has risen to a record 84.8 percent of gross disposable income.
Economics professor and real estate expert Michel Mouillart sees few options left for the sector short of allowing smaller deposit payments than the 20-25 percent usually required.
"If we want to revive construction without using more debt or more public aid, all you have to do is make the French rich," Mouillart quipped.
French housing investment: http://link.reuters.com/jah69v
French house prices: http://link.reuters.com/tyx36t
House price valuations: http://link.reuters.com/syx36t
European house prices: http://link.reuters.com/kap37t
(Editing by Catherine Evans)