London's Real-Estate Gold Rush

Prime London commercial real estate has emerged as an improbable postcrisis safe haven. Despite the U.K.'s precarious economic situation, international investors poured more than €6 billion ($8.17 billion) into London offices and stores in the 18 months to June 2010, almost as much capital as the next nine most popular cities combined, according to CBRE. Having fallen 50% from its peak, City offices have outstripped every other European market, at 25% higher, compared with a mere 2% gain in Paris, according to Investment Property Databank. But with some West End offices now changing hands at yields as low as 4%, global real-estate investors can find better value elsewhere.

For property investors, London's appeal lies in its perception as a reliable store of value, the real-estate equivalent of gold or the Swiss franc. International investors value its transparency and liquidity. Access to deals is open, unlike parts of Europe and Asia, where foreign investors are often shut out of the bidding or where legal protections are weak—making it hard to deploy capital. Investors are also attracted to its relative stability: Average leases on U.K. offices at 7.5 years are more than two years longer than in Germany. Prime London property is relatively decoupled from the fortunes of the U.K. economy and has been boosted by the pound's weakness.

But asset prices have started to become divorced from the fundamentals. London West End offices yield just 4.25% and City offices, 5.25%—close to the peak of the boom levels. True, 10-year gilt yields have fallen since then to 3.6%, but interest rates are likely to rise next year and rental growth is uncertain. London City office rents fell in real terms by 4.2% over the past decade, a steeper decline than in Frankfurt and Paris, according to IPD. Further, U.K. banks hold billions of pounds of secondary commercial real estate, which they may start unloading in 2011.

So, what should investors do? Within London, the smart money is now focused on new developments, betting that the supply of inward investment will remain strong while the supply of investment opportunities will remain weak. The pipeline of new office developments is running at less than half of the 25-year average. That also means there is likely to be a shortage of new office space available in 2014, when a large volume of long-term City leases start expiring, helping to boost rental growth. Land Securities, which is planning to start development on four London sites this year, is forecasting unleveraged returns of at least 14% on these ventures.

But for real-estate fund investors, other European markets now look more enticing: German shopping centers are benefiting from the strongest consumer outlook since reunification and yield 5.5%-6.5%. Investors also point to Paris offices, where the recovery has been slower. Swedish property, buoyed by an economy that grew 5.5% last year, also looks like a good value, despite the recent yield compression. With London an increasingly crowded trade, expect to see more international capital flow to these markets.