Time to invest in central London office? The end of the year may be a good opportunity, but investors must move quickly, says Clive Castle

Last year proved to be very dramatic for global financial markets as the magnitude of the crisis engulfing the banking sector became fully apparent and spilled over into the real economy.

The fallout from the liquidity crisis will continue to have a significant impact on the real estate markets in the short term. The recent rally in equities markets, albeit from a distressed low, is a promising signal that possibly the worst has passed, although a significant fall in output in 2009 is certain. UK growth projections for 2010 remain modest and largely reflect radical government policy to restore market confidence and liquidity.

Leading financial centres such as London, which are historically very volatile in terms of employment and output, will once again be reliant on a recovery in global investment and demand for internationally traded services. The current slump in borrowing and world investment points to continued falls in business activity and office employment in the near term.

However, as confidence returns to financial markets, London's global competitive edge, which includes its skilled labour pool and established financial infrastructure, together with its ability to adapt and grow to the challenges inherent in banking and finance, will ensure that it is well positioned to emerge strongly from the present crisis. With this support for future occupier demand, the central London office market is capable of producing highly attractive returns for those investors who get their timing right and are able to take advantage of its cyclicality.

Capital values in the central London office market have undergone a marked correction with latest evidence from IPD showing that capital values have now fallen close to 50% from their peak in June 2007. The suspension of securitisation instigated by the credit freeze has cut off a relatively low cost route to borrowing, and leveraged investment will be sharply restricted in future, as banks with little appetite for lending to the real estate industry seek to re-balance existing loan books.

The substantial correction in capital values has put many borrowers in breach of loan to value covenants and banks have so far adopted a pragmatic approach as long as adequate interest cover is maintained. However, contraction in bank lending is likely to bring more assets to the market over the next couple of years as a significant volume of loans come up for refinancing.

The London investment market is attracting interest from a diverse range of investors and the volume of investment turnover is increasing. This is a reflection of both the significant yield re-rating which has occurred in the UK ahead of many other global real estate markets and also the fall in sterling which has made London property even more attractive for overseas investors.

Investment demand is mainly concentrated on a narrow band of investment stock offering longer-term income streams and let to strong covenants. As a consequence, there is a realisation that yields are stabilising with yield compression evident for prime assets which meet the requirements of active purchasers. Investor appetite remains more limited for properties with short income streams and the differential between prime and secondary yields is widening as investors seek realistic rewards for risk.

Despite evidence of yield compression for prime assets, conditions in the occupational market remain challenging and falling rents will have a negative impact on capital values in the short term. Sharp falls in net absorption have driven rents rapidly lower as office availability has increased. The adjustment in rents has been dramatic and prime rental values have already fallen by around 35%. The decline in rental values is continuing but it is likely that a significant proportion of further anticipated reductions will be concentrated in the second half of 2009, with limited further falls continuing into 2010. There is a general expectation that rents will record a peak to trough fall in the order of 40-50% with variations between sub-markets and different grades of space.

Letting incentives have also increased substantially and the reduction in net effective rents is much more substantial than indicated by movements in headline rental levels. It is interesting to note that in real terms prime headline rental values in the City remain at the lowest level yet recorded with West End rents also looking very affordable based on long term comparisons. Projected vacancy levels remain below the levels of the early 1990s recession, due mainly to lower levels of development activity. New construction starts have evaporated and development completions should fall considerably between 2011 and 2013, paving the way for rental recovery as occupier demand improves.

It is anticipated that rents will begin to recover from 2011 for prime assets and 2012 for average assets. While the next rental growth phase is expected to be less pronounced than after the recessions in the early 1990s and early 2000s, potential exists for the recovery in rental values to be stronger than anticipated having regard to long-term affordability and the modest level of expected development activity.

With rental levels adjusting rapidly, transactional prices should fully reflect realistic assumptions regarding rental levels by the end of the year. Consequently, investors entering the market from the end of 2009 should be confident that they are buying at a favourable point in the market cycle. Central London cycles tend to move quickly and the acquisition environment will rapidly become more competitive once investors perceive that the occupational market is approaching a floor, leading to more widespread yield compression.

Continued restrictions on the availability of debt finance will ensure that the next phase of the market cycle is dominated by investors who are not reliant on high levels of gearing. This will reinforce the importance of traditional property fundamentals and asset management. Cash-backed institutional investors will be in a stronger position than in the last upswing when they faced strong competition from highly leveraged investors.

A successful investment strategy will need to identify the best assets in a competitive market and to differentiate between investments that are ‘cheap' and those that offer real value. While it is difficult to generalise, this is likely to favour better quality assets with strong medium-term income streams and larger lot sizes for which there will be less competition as debt finance for real estate remains constricted. Multi-let assets are more likely to provide opportunities to enhance returns through active asset management and provide greater diversification in terms of income security.

In a complex and fast moving market such as Central London, investors need to adopt a flexible investment approach in order maximise returns. Clive Castle is fund manager at Henderson Global Investors