Investors claim to be peering at the bottom of the London property market. Some are already looking for sane prices for sparse assets - and they include pension funds as well as opportunists. Shayla Walmsley reports

You can differentiate a major capital from the rest of the country. London, for example, is closer to New York than it is to Manchester because it's focused on finance and international trade, according to Alan Paterson, head of European research and strategy at AXA.

If the correction in the UK commercial office market has taken the capital with it - or vice-versa - the exception has been the City of London. Here, the drivers are different, and the risk of oversupply much greater. Transactions in the City halved in Q3 compared with the previous quarter following British Land's decision to call development of the trophy Leadenhall building to a temporary halt.

The shuddering to a halt of a single development doesn't make a market crisis, but the temporary demise of a trophy designed to emblazon London's status as the world financial centre speaks convincingly of declining market confidence. In fact, the City is an exception to an otherwise optimistic forecast from Schroder, with expected falls in value of close to 40% compared with 20% in the rest of London - though "we're already seeing some investors seeking opportunities from the upswing", says Mark Callendar, head of international property research. 

In any case, there is some evidence that the threat of a City surplus has been overstated. The Drivers Jonas Q3 Crane Survey found that development activity was slowing sharply in the City, with construction activity down 20% over the previous six months and a 17% decline in speculative space during the same period. 

"With viability, demand and funding difficulties, we don't expect more starts any time soon," says the report, pointing out that only the Heron Tower is scheduled for completion after 2010 (in 2011). "With little (if anything) forecast to start in the immediate future, the City is again setting itself up for another cyclical upwards movement in rents once the existing supply overhang has been eroded."

There are question marks over this optimistic forecast, of course - not least being uncertainty over how long it will take to absorb excess development already underway and, more broadly, how long it will take the financial sector to recover. Despite JPMorgan's recent announcement of the €280m relocation of its European headquarters to Canary Wharf, the Square Mile's riverside outgrowth is still significantly exposed to volatility in the US financial services sector.

Holding off from acquisitions for a year will give investors a better measurement of oversupply, according to Joe Valente, head of portfolio management and strategy at Allianz Real Estate. "By 2010-2012 you'll see a shortage of new buildings. There is no debt now, so it's difficult to develop anything."

In the West End, in contrast, the Crane survey found continuing construction - though only on two major projects. A diminishing pipeline, however, is unlikely to keep pace with even more rapidly diminishing demand. "Despite this low level of supply, weak demand will still cause rents to fall. But, when compared to other parts of London, the West End does look better placed to weather the downturn," conclude the report's authors.

At a recent roundtable on the UK property market, Schroder property CEO William Hill suggested that London would emerge as a "two-speed market", with stability in 2009 at the prime end (except, notably, for the City of London).

His assessment raises another point about the UK capital: investible property is prime property. "Investors are only interested in quality assets," says Valente. "The only assets to find buyers in the current market are prime, and those it's hard to find because they're very rarely placed on the market."

It isn't only the market but the metrics that matter. In London, Valente points out, valuers are much quicker to value downwards. "The language around the market is emotive, whether it is ‘stressed' or ‘distressed'," he says. "No investor would sell property in the current market unless they have a reason.

The challenge is to find out what it is. Sooner or later, it comes down to financial distress."  His point suggests a renewed focus on due diligence. "It's of paramount importance," he says. "Many people forgot about due diligence in 2005—2006. There was an assumption among many people that it wasn't necessary - but how wrong they were."

Despite the predatory circling of opportunistic buyers in the UK capital, the reluctance of potential sellers to expose themselves as forced sellers has slowed property transactions to a reluctant trickle. The few acquisitions there have been have indicated opportunistic re-entry of investors pre-empting prime at what they expect to be the near-bottom of the market.

"We are looking for core assets in good locations. But there will be only forced sales in 2009. Anyone able to keep their property through 2009-10 will do so," says Hans-Joachim Kühl, a board member and head of real estate acquisitions at Commerz Real. The Commerzbank property subsidiary re-entered the City market in July this year with the €124m acquisition of a central London office block. That deal followed a three-year absence from the capital after Commerz Real's acquisition of the Lloyd's building in 2005.

"When we went back to the UK market in the summer of 2008, our assessment of the market then was different than it is today," says Kühl. "When the market was at its peak, we couldn't afford to invest in it. In the spring and summer of 2008, we perceived potential for return levels for the fund even if the environment was not optimal."

Kühl forecasts further falls in 2009. "The market will go down. By 25 basis points? By 50 basis points? It probably depends on the property and its location. There are opportunities for liquid investors to secure assets at decent prices in London but there isn't a good supply of potential properties. We must take care that the rent review situation will be positive in 2012-13 - it is important to take the rent review situation into account."

Yet his optimism is not just based on likely rental uplift. "If you get the property, in the medium and long term there will be an uplift in value, too. If you buy in the right conditions, there is potential on the value side and on the letting side," he says.

According to data compiled by DTZ, the percentage of foreign investors in the UK market increased from 21% of the total in 2001-02 to 31% in 2005-06, dropping slightly to 28% in the first three quarters of 2008. Domestic investors were led by pension funds reweighting, to a lesser extent, property companies. Overseas investors in the same market were dominated by US funds, sovereign wealth funds and German open-ended funds - all of them looking primarily at central London offices.

Research published by Cushman & Wakefield in October confirmed that overseas investors were still willing to consider London acquisitions despite a 40% fall in central London transactions in Q3 2008 from €1.61bn in the previous quarter.

"What I'm seeing are two kinds of investor coming back into the market," says Valente. "Entrepreneurial companies are coming back into the market with capital they've collected in the past few years. The other investors are major institutions - whether they're the Canadian Pension Plan, Allianz or [Singapore sovereign wealth fund] GIC - seeing the beginnings of the recovery."

It's a telling distinction, not least because there is no clear distinction between opportunistic and long-term investors active in the London market. Ropemaker Properties, the real estate subsidiary of the £18bn (€20.6bn) BP pension fund, in October announced a £100m joint venture with Cube Real Estate aimed at acquiring distressed commercial property valued at less than £10m and with the potential for active management.

"The partnership will be opportunity-led. The remit is simply to invest in sub-£10m management-intensive assets across the UK. There are no definitions in terms of sectors," says Tim Hayne, head of property at BP Investment Management.

A second BP pension fund partnership, this one with Great Portland Estates, targets assets valued above £10m. That partnership, set up at the beginning of the year, has switched its focus from the West End to the City. "It's about yield recovery, really - for income," says Hayne. "There aren't many of those assets. In fact, we haven't bought anything yet with either partnership.

What's interesting about pension funds currently active in - or at least scouting - the London market, however, is the fact that the decision to invest pre-dates the recent volatility. In other words, they're making the best of bad timing. "We knew in April we would do it, but the documentation took to September to work out," says Hayne. "So It wasn't set up as a recovery fund, though it may become one."

Paterson points out that pension funds invest for the longer term: they made the decision to invest in London property a few years ago, and they'll stay with it. Even so, buying central London offices is too big an investment for most pension funds - you have to be a reasonably big pension fund to do it - and most will opt to invest via a fund or a joint venture.

APG Investments, the asset manager owned by ABP, the €193bn Dutch civil servants' pension fund, is a case in point: the (albeit large) scheme focuses on indirect investment via securities, funds and joint ventures. Patrick Kanters, managing director of global real estate at APG, says pricing in the current market favours listed over non-listed investment - but with capital sidelined for investment in opportunity and special situation funds targeting distressed portfolios and companies.

"The UK has been at the forefront of a repricing in the European market, influenced by its higher transparency, international investor base and severity of the financial crisis," he says. "This is expected to generate many opportunities across all sectors."It's a truism that, if you're looking for the bottom of the market ,you've probably just missed it. The best investors can do, says Valente, is to look at pricing and decide whether they can live with it.

Maurizio Grilli, a senior research analyst at Grosvenor, suggests pension funds wait another year before making a wholehearted re-entry into the London market. "Investors should think about going back into the market because we're close to the bottom - but not yet," he says. "The advantage of not waiting is that there is a lot of distressed product. In 12 months, it could be the right time to look around."

London's advantage is that it will act as a barometer for major cities in the rest of Western Europe. It's a question of first in, first out. "London - the UK, in fact - was the first market to enter the property crisis so it is leading the cycle.  There is a downturn everywhere, including Asia, but history tells us that London leads. The fluctuations have been extremely violent - which means a violent downturn but also a violent upturn," he says.

Despite the prevalence of investors looking for value in a close-to-correcting market, it may well be that the worst is yet to come - that recession will stultify with unwilling tenants pension funds' most earnest efforts to invest. While investors such as Commerz Real focus on rental uplift, Paterson separates his prognoses into two phases. Currently, we are well into the first phase, with a correction of the previous overheating and yields predicated on further growth.  In the second phase, rental value growth will tail off. "We haven't had a great fall yet, but there is no way it cannot fall," he says.

"The correction will be deep and quite long. We're just starting to see the effects," he adds. "There will be further falls until 2010, and three-four years before the recovery. Rental values lag the economy by 12 months; then there is a 24-month lag after the downturn, with caution from tenants. "In other words, even once we're through the recession, there will be more caution."