Somewhere over the Thames, the vultures have begun to circle. With prices down as much as 50% in the past 18 months, London's offices look like a bargain to some investors.

No one has swooped in yet, but foreign investors have started looking at smaller, high-quality buildings in the tony West End.

Assuming these signs of life do lead to sales, it would be good news not just for London but for the New York office market, which has generally followed London's office market lead in the past two years.

Fire sale

In the first half of 2007, London had the strongest office market on the planet. Demand was so high that the average capitalization rate — the initial yield to buyers based on the purchase price — fell below the cost of money, reports Mat Oakley, head of commercial research at Savills property consultants in London. In January 2007, yields were only 3.5% in the tony West End, and about 4.5% in the City, London's financial center, against an interest rate of 5.25%.

That summer prices began to fall in London, and by October 2007 cap rates began to rise. About six months later, cap rates in Midtown Manhattan also turned upward, reports Real Capital Analytics.

Even before the credit crunch hit, a local price bubble had begun to pop, Oakley says. The credit crunch aggravated that pressure, raising the cost of capital, pushing down transactions, and sending cap rates flying.

Currently, London office cap rates range from about 6% in the West End to as high as 7% in the City, says Oakley, and prices have fallen as much as 50%. Meanwhile, Cushman & Wakefield estimates prices in New York are down at least 30% over the same period.

The buyers casing London these days are mostly non-sterling investors, drawn in part by bargains created by the shrinking British pound, Oakley says. A pound is now worth about €1.13, down from €1.33 a year ago. Against the dollar, the decline is even steeper, down from $1.97 to $1.44.

Most of the shoppers are either equity-rich, or locked in financing some time ago. German open- and closed-end funds are leading the charge, followed by Middle Easterners, Russians, a few Americans, and a handful of global funds, including major pension funds and insurance companies.

Most have set their sights on the top 20% of the market: dream buildings that sell for less than £50 million (U.S. $70 million), are 100% occupied on 10-year leases, and have rent reviews every five years that can only be adjusted upward, Oakley says.

Bill Page, an analyst for Jones Lang LaSalle, pegs the sweet spot at closer to £10 million (U.S. $14 million). Still, even 10 years of guaranteed rent at a 6% or 7% cap rate isn't enough to get many to buy.

But not even 10 years of guaranteed rent at a 6% or 7% cap rate is enough to close many deals.

Bottom still to come?

What are they waiting for? The chance for even bigger bargains. “There's more to come, but less aggressive and less speedy than we've seen over the last 18 months,” Page predicts.

Page forecasts prime office space won't bottom out until the third or fourth quarter of this year, and secondary space probably not until sometime in 2010.

Cushman & Wakefield estimates that rents for Class-A office in the city fell 20% in 2008. They now stand at £52.50 per sq. ft., roughly U.S. $70, and Cushman expects them to fall another 14% in 2009. In the West End, meanwhile, rents are down 23% and incentives are triple what they were in the downturn 12 years ago.

One rare bright spot is that the overall office vacancy rate is still around 5%, according to brokerage CB Richard Ellis, and should not climb all that much. The credit crunch killed a number of plans for skyscrapers, and there is little new supply in the pipeline.

“Once the investment markets have stabilized,” says Oakley, “the vacancy rates are going to come down quite fast and rents will recover quite fast.”

Bennett Voyles is a veteran commercial real estate reporter and NREI's Paris correspondent. For questions or comments, readers can e-mail him at benvoyles@yahoo.com.