Investor mettle is being severely tested as the gloom around London office deepens. It is not all bad news, but timing will be critical, says Andy Schofield
  
     
The global financial system is in a crisis the likes of which have not been seen since the 1930s. In its ‘Global Stability Report', the IMF explained how private sector risk management and financial regulation had lagged innovations in financial models, leaving scope for excessive risk-taking and leading the banking system to the brink of collapse.

Throughout the post-war decades financial crises have periodically occurred, but the current situation differs in the way that it has moved so quickly from one segment of the market to another. The real-economy costs are only just beginning to unfold and the lasting legacy could be significant changes to banking models and market structures. Leading financial centres, particularly New York and London, will be the focus of this transition.

For real estate, the short-term consequences will be severe as investors digest the impending hit to occupier markets. The death of securitisation has cut off a relatively low cost route to borrowing and leveraged investment will be sharply restricted. The short-term focus of the banks will be on fire-fighting problems within their existing property loan books. Many loans will need to be repaid or refinanced and this will characterise activity in 2009. The banks will have little appetite for new lending to the real estate industry over the next few years.

Having already undergone a marked correction, capital values in the central London office market are set for a further hit as rents collapse. The outlook for short-term investment performance is dismal. On the bright side, the seeds of an eventual recovery in the City occupier market have been sown with the halting of development activity. And, although the City will undergo a huge shake-out in jobs in the financial services that have generated rapid growth in recent years, it is important to keep sight of the competitive advantages that have positioned it at the heart of the global financial system.

In terms of the economy, analysts are agreed on the projection for a sharp fall in output in 2009. Opinion is divided as to when it might recover thereafter; more gloomy scenarios envisage further output falls in 2010, while the optimists are backing a modest recovery from 2010 on the back of the radical policy response already implemented. The outcome will depend on the banks and their ability to rebuild their capital base and restore credit lines to the economy.

In the meantime, the policy makers will be challenged to implement innovative measures to combat deflation as the base rate heads towards zero. What is almost certain is that the London economy will be disproportionately hit by the recession. London is typically more volatile than the rest of the economy in terms of the fluctuations in employment and output.

During the credit and asset price boom, the buoyancy of the City explained around one-third of the UK's overall economic growth, despite accounting for just one-tenth of output. We are now seeing City-based financial services and related activities contract sharply, with a huge and growing cost to jobs. Even if we are very fortunate and the UK economy begins to stabilise by late 2009, the impact on commercial property values will still be significant. Average occupier rents in the City could record a peak-to-trough decline in the region of 50%, while prime rents bottom out at £40(€44)/ft2 in 2010.

The West End might fare less badly in terms of total decline, but its fortunes are closely related to those of the general economy because of its broader occupier base. This market suffered a peak-to-trough rental decline of 67% in the 1990 recession, compared with a 77% correction in City values. Good news is in short supply but, as already mentioned, the curtailment of new City development represents a flickering light at the end of a long tunnel.

New construction starts have all but evaporated and completions should fall substantially between 2011-13. In fact, compared with the 1990s' development cycle, which delivered 15m ft2 of new space between 1988 and 1994, the current cycle will provide a more modest 10m ft2 by 2010. Of course, the big unknown is the extent to which occupier releases frustrate the overall level of City availability, but even here there are grounds for guarded optimism.

There is unlikely to be a major occupier shift from the City to the Docklands as occurred in the early years of this decade. Between 2001 and 2003, City availability suffered when a number of high-profile occupiers defected to Docklands, releasing over 2.5m ft2 of space in their wake. This included the release of 900,000 ft2 by HSBC, 700,000ft2 by Barclays, 350,000 ft2 each from Lehman Bros and BP, in addition to some smaller releases of between 120,000 ft2 and 150,000ft2 by Credit Suisse and Bank of America.

This will not be repeated and the only known large scale defection to Docklands announced to date is JP Morgan, which has signed a pre-let for 1.9m ft2 at Riverside South. The bank could vacate a total of 600,000 ft2 in the City in the process, but this move is unlikely to take effect before 2012, by which time the City occupier market should be in recovery mode.

The eventual recovery in London office rents seems distant as the market expects a sharp correction. Take-up levels will weaken to well below their long-term averages and a significant number of speculative pipeline developments are set to complete in the City. The City's vacancy rate is expected to soar and will not return to a level consistent with accelerating rental growth across the market until 2012, or perhaps 2011 for prime offices. From 2012, the recovery in rental values could be strong, reflecting the good-quality, affordable space on offer.

The West End should experience a similar profile, although its significantly lower exposure to completing projects over the short term implies the amplitude of its rental cycle may be less marked. If the economy improves in line with the views of the more optimistic pundits, the West End market could witness a stabilisation in rental values ahead of the City. Further out, however, it might be prudent to assume the next growth phase will be less pronounced, particularly in the early years of the recovery.

UK GDP growth could prove to be a relatively muted if households and the government continue to deleverage in order to restore their balance sheets, marking a contrast to the above-trend growth backdrop of the previous cycle. In addition, the recovery in prime rents following the dotcom recovery was led by an explosion in demand from hedge funds, eager to secure prime Mayfair real estate. The industry might not provide quite the same impetus in the next growth cycle.

Because of the volatility of the rental cycle, Central London offices normally represent a speculative play for investors. The degree to which investment volumes will improve in 2009 remains to be seen, but potential forced sales of assets by those funds unable to meet their debt interest cover might well tempt equity-backed investors to take the plunge, despite the ensuing occupier market turbulence.

The growing gap between initial yields and fixed interest rates is attractive, even assuming punitive margins on debt, and will improve further in 2009 as yields continue to soften. In addition, sterling's exchange rate depreciation has amplified the commercial property capital values for euro-denominated investors. However, despite such positive signals flashing onto the radar screens of investors, a widespread recovery in yields is unlikely until 2010.

In previous cycles, re-entry into property has been associated with lower policy interest rates, which investors assume will underpin a recovery in the real economy and translate into the next growth phase in rents. In this instance, however, the jury is out on the timing of the economic recovery. Although we have witnessed some dramatic reductions in interest rates in recent months, the normal transmission mechanism between the base rate and the real economy is frustrated by the collapse in banking confidence.

A general recovery in property yields will probably only occur once banks have satisfactorily re-constructed their capital base and narrowed their funding gap. This will take time and will require a sustained upturn in equity markets and banking stocks. A more worrying scenario would therefore be if the banks were to suffer further write-downs in 2009 and the stock market fails to recover.

London is sensitive to trends and fluctuations within the global economy because it is both a driving force for and a reflection of the trend in globalisation.Neil Blake of Oxford Economics highlighted the long-term relationship between London's office jobs and world investment at the recent IPD/IPF conference. Oxford Economics expects world investment, excluding China, to contract in 2009, as it did in the 1990 recession and in 2002 after the dotcom crash.On both occasions this was accompanied by substantial job losses in the City. Blake also demonstrated a long-term relationship between the ratio of private sector debt to GDP and office employment, explained by bank lending cycles and the resulting demand for staff.

He concluded that the current slump in borrowing and world investment points to inevitable sharp falls in office employment in 2009 and 2010, and argued that the labour market would recover only after banks' insolvency problems had eased and the next investment cycle is financed.

The long-term demand for office space reflects the underlying economic and workforce growth and this is perhaps why the London office market, for all its volatility shortcomings, is capable of producing good returns for those investors who get their timing right.

According to a report for the Greater London Authority, there are roughly 1.5m jobs located in London's central business district (CBD), although this figure might look slightly less impressive after the full impacts of the financial crisis have worked through. The capital's occupier appeal arises from its critical mass of skills, knowledge, inputs and markets, which encourages growth and supports innovation. The sheer scale of choice allows businesses to pick and mix according to their requirements and, for many firms, a CBD location is critical to competitive advantage.

Cushman & Wakefield's European Cities Monitor in 2007 ranked London as the lead city on a broad spectrum of categories, including availability of staff, access to markets, quality of telecommunications, transport links to other cities and to international destinations, languages spoken and, perhaps surprisingly, travel within the city.

The capital scored less well on staff and office costs and on non-direct business considerations such as pollution and quality of life. London's CBD is also unique because of its linkage to other cities and to international financial centres.

Although regional cities in the UK also have strong financial sectors, these tend to be orientated towards retail rather than wholesale services. As a result, the overwhelming share of the UK's exports of financial and business services are accounted for by the CBD. Although the CBD is currently at the centre of the financial crisis, and will probably be subjected to a tighter regulatory regime, it should remain well positioned to benefit from the geographic shift in the balance of power in the world economy.

The growth in India and China will present major opportunities for London as a provider of global financial and business services, and the creation of a dedicated unit at the London Development Agency probably reflects a belief that London has not yet engaged sufficiently with these economies.

London has shown before that it has the ability to re-invent itself. Its competitive advantages should stand it in good stead for when it emerges from this current crisis, hopefully fit and ready for the challenges of the next decade.

Andy Schofield, European Research Manager, Henderson Global Investors