Uncertainty abounds in the London real estate market, not least due to financial sector worries. However, overall interest remains keen. Richard Lowe reports

London recently retained its number one ranking in an annual report by LaSalle Investment Management that looked at the prospects for economic growth among top European cities. One of the crucial factors behind the finding was the strength of London's financial sector, which not only dominates the city's economy but also rivals New York in many ways.
London is the "first port of call for overseas buyers", according to Alistair Seaton, national director at LaSalle Investment Management. "It is large, liquid and one of the most transparent real estate markets in the world," he says. "Therefore, it is an obvious place for overseas money to come."

Certainly, where pan-European investments are concerned, it makes little sense to omit London from a portfolio.

"Most of our capital is pan-European and if you take that away from London where do you invest it?" asks Rob Johnston, head of UK transactions at Invesco.

"London has a part to play in any European, or indeed global, strategy. It is still the number one global financial centre in all the ratings and rankings, so it is always going to attract occupiers.

"If you are an institutional investor with a long-term holding policy, you should be in London. The story is good, the growth prospects are good, the economy is solid."

There are also certain characteristics that are unique to London as a European marketplace and which make the region inherently attractive to real estate investors throughout the continent. These include unrivalled transparency, a robust landlord-and-tenant system and upward-only rent reviews.

"The UK has a lease structure that is uncommon," says Andrew Allen, head of research and strategy at Cordea Savills.

"It is very landlord-friendly and it is very fair to the tenants. The leases are long and the obligations are very transparent. For those reasons, the London office market is often seen to be very attractive by international investors."

Having said all this, however, the market is currently undergoing a period of uncertainty. The office sector has enjoyed low vacancy rates and relentless rental growth in recent years, spurred by huge demand and insufficient supply. But the London real estate market is a cyclical one and is today nearing the end of its rental growth phase. Certainly, the low yields of last summer were cause for concern for London property investors given the timing of the market.

"It was difficult to see how yields could be sustained at that level or how you would get an acceptable level of return bearing that in mind," says Kim Politzer, European investment research manager at Invesco.

Since then, yields have moved out significantly and so London properties are looking more fairly priced given declining rental growth prospects. But the market has found itself pausing for breath as property owners have been reluctant to sell and preferred to engage in wait-and-see tactics.

"Because we are seeing so few deals at the moment, we have an idea of what you would get if you were trying to sell a building today, but no one is actually trying to sell one at this sort of price," Politzer says.

"So, there is a sort of hiatus at the moment, waiting for evidence and waiting for buildings to come on to the market and actually seeing what the pricing really is."

But perhaps one of biggest concerns surrounds the likelihood of significant job losses in the troubled financial sector, still reeling from the sub-prime fallout. If redundancies in London turned out to be greater in number than expected, there could be a sharp drop in office demand. Furthermore, if this coincided with a glut of new property developments coming on to the market (7m ft2 of development completions are expected in 2008, according to CB Richard Ellis and ING REIM forecasts), the London office sector could feasibly enter into a period of oversupply in the coming years.

Forecasts from the Centre for Economics and Business Research (CEBR) in the UK have put the number of London financial service sector redundancies in 2008 at 6,500. According to reports this would be enough to empty the City's landmark Gherkin building twice over. Whether such a reduction in jobs would have any notable impact on the market is a matter for debate (as is the usefulness of trying to predict employment trends in such a volatile sector).

Clive Bull, head of central London investment at Cushman & Wakefield, believes the potential loss of 6,500 financial jobs has to be considered in the context of the total size of the market. In fact, Bull believes there are figures to suggest that London has been creating significantly more jobs than the CEBR figure as a whole.

"While the prospect of 6,500 in the financial services sector would be a concern, if you look at the overall picture, I suspect it is not massively significant."

Politzer admits she would be concerned if CEBR's forecast turned out to be true - given that there is "an enormous tranche of space being completed in the City next year" - but, like Bull, she is quick to put it into perspective.

"Demand appears to be holding up at the moment; there is no clear panic in the market. In the last downturn in 2000-01, many key office occupiers were sitting on a lot of space they weren't fully occupying, and therefore a recovery took quite a long time to come through because they had to fully occupy the space they were already paying rent on before they could start expanding.

"Anecdotally, the stories I've heard are that a lot of the key occupiers in the City are fully occupying their space at the moment. Therefore, if the downturn isn't as significant, they are probably going to need to expand and look for further space fairly quickly.
"And even if a downturn does result in their cutting jobs, they are still not going to have a lot of spare space to absorb new recruits once the market does pick up. I think it will be quite a short downturn, if it is a downturn."

Another point to consider is whether the pipeline of new office developments would necessarily compound a drop in demand. Consent for many of the new proposed towers was gained at a time of strong demand. Who is to say that some will not take longer than originally envisaged to come to fruition now that the market environment has changed?

Bull explains: "With a lot of these towers, people have obviously been running around trying to gain consent to get them approved. But I think there is a world of difference between getting a consent on one of these towers and actually building it.

"While maybe one or two might start on a speculative basis, I can't see them all happening. And I think a number of them would only start if they had a significant pre-let anyway. So, I think people will always be looking at the risk profile of the market and that will in turn determine when they decide to actually commence development."

Because of its volatility and cyclical nature, London real estate needs to be approached as a tactical investment, something that domestic investors are well aware of. West Midlands Pension Fund employs ING Real Estate Investment Management to operate an underweight/overweight position to London "at the appropriate points in the cycle".

While it does currently invest in central London, "the window to invest tactically in central London closed some time ago", according to the UK local authority pension fund and ING REIM. For this reason, the fund is not currently expecting to make any additional investments in this sector.

"Given events in the credit market over the summer, the precise demand outlook remains a little less transparent than normal. Nevertheless, on the supply side, local office vacancy rates are currently very low which should encourage further rental growth. Over the medium term, like other mainstream UK property sectors, London yields are now moving out."

West Midlands and ING REIM believe that one of the byproducts of this is that the office development pipeline is now likely to stall. Consequently, the pension fund has changed its expectation of a "development-completion-led oversupply" in 2010 and 2011 - "after the normal two-to-three year construction lag" and is keeping the timing of its tactical exit from the market under constant review.

Dutch industry-wide pension fund PMT, meanwhile, has invested in a number of opportunistic real estate funds that have London within their geographical scope. In 2006, PMT invested in Greycoat, a fund that has a focus on office development in the City and West End.

The fund's investment officer, Theo Jeurissen, explains that strong rental growth expectations at the time "convinced PMT to target this market focused and aggressively".

Jeurissen believes the supply side is "pretty foreseeable" for the next three to five years, "due to long planning and permit processes", and expects rental levels to continue growing until 2009.

"That is when we expect supply and demand to be balanced again. In 2010-11, rental levels in the City might fall a little bit (something we don't expect for the West End and Mid-Town). After 2011 it is hard to predict anything, but for now we expect a stable market."

Last year there was a marked short-term decrease in UK institutional investment in central London as a proportion of total capital flows. According to Data Property statistics, UK institutions were responsible for almost 30% of all London purchases in 2006, dropping to just over 10% in the first three quarters of 2007. Furthermore, net investment in London offices by UK institutional investors in 2006 was approximately £2.8bn (€3.9bn), whereas in the first three quarters of 2007 it represented a negative value of £887m, taking into account purchases and sales.

"There has been quite a shift in terms of who the main buyers are, for central London offices in particular," says Seaton.

"The majority of buyers are now overseas investors. We have seen a reduction in UK institutions' interest in central London, but actually an increase in the activity of overseas buyers."

UK retail institutions, for example, were previously "the most aggressive institutional investors", says Bull. Unitised funds were effectively gaining "massive inflows of money from ‘the man on the street' ticking the property box with his pension contributions, etc".
This trend has changed, however, spurred by common perceptions of UK property pricing starting to slow and unitised funds consequently having less capital to invest in London property.

"When those funds are faced with a reduction in inflow and a potential redemption liability, clearly they are not going to be buying and in some cases they are having to start to sell."

That UK institutions have "largely withdrawn from the market" has given more room to overseas institutions, Bull continues.

"Everyone is aware that some of the increase in pricing was due to the competition between the domestic UK institutions trying to get their allocations in to the West End and the City markets. That competition, arguably, drove prices beyond a sustainable level from a valuation perspective."

Bull says he has seen a renewed interest from German institutional investors. "Traditionally, they have always found London and the UK a sensible home for their money. What stopped them in the past was the low level of yield and the competition from the UK institutions.

"If those UK institutions aren't so active and yields move out a little bit, then I see no reason why they wouldn't come back in. And they've indicated they are certainly looking at the market."

Johnston also thinks German investors may well be making a return to the market. "There is no doubt that we are going to see more of German investors active again over the next 12-18 months, as we start to see these price differentials start to kick in. They led the market three, four years ago, went quiet and could well be back again."

Christian Voelxen, rating analyst at FERI Rating & Research, does not expect an influx of German pension funds to the market in the short term. This he attributes to German funds currently seeking core properties, which they will be unable to source in London because they are too expensive. "Yields are at about 4% and this is not interesting enough for them," he says.

The situation is compounded by the fact that the market cycle has peaked and, furthermore, German pension funds are averse to being exposed to sterling currency risk, given its current strength.

In the medium term it might be a different scenario. Voelxen believes that if yields "significantly come down again on a more promising level" then German funds might well increase their London property investments, "but not within the next 12-18 months", he says.