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As the credit crunch continues to paralyse the financial markets, is the Square Mile about to turn pear-shaped? Banks in the City of London have not only reduced lending to property, but are not keen on occupying more than they have to, shelving expansion plans and potentially slashing tens of thousands of jobs.

Yet in a hangover from the days of cheap finance, a total of 5.5m sq ft of speculative uncommitted office space will reach completion in the City over the next two years. With precious little active demand, this oversupply will be exacerbated by job losses and the 鈥榞rey space鈥� occupiers return to the market for sublease.

Calculating these varying 鈥榮hades of grey鈥� is a gruesome guessing game. The Centre for Economics and Business Research forecasts 10,000 City job losses this quarter.

鈥楢pplying a rough rule of thumb of 150 sq ft per person, this means another 1.5m sq ft of grey space will have to be accounted for,鈥� says Lehman Brothers real estate analyst Mike Prew. 鈥楾hat鈥檚 the equivalent of three empty Gherkin buildings 鈥� to add to the 11 empty Gherkins coming from uncommitted construction.鈥�

However, JP Morgan has estimated up to 40,000 City jobs will be lost by 2009 鈥� using Prew鈥檚 rubric, a staggering 12 empty Gherkins, or 23 when combined with speculative space. Moody鈥檚 has downgraded the City鈥檚 office market to 鈥榗ode red鈥�, predicting 鈥榠mminent stress鈥�, not just for property values but office rents too.

Since last autumn, property values have been in freefall because of the financial system鈥檚 inability to fund debt-backed purchases. A 鈥榮hort, sharp shock鈥� of 15% -25% has been wiped off the value of standing investments, and the Bank of England estimates Britain鈥檚 banks stand to lose 拢5bn from their commercial property investments.

Now, as waning occupational demand and oversupply come to bear, analysts expect a 鈥榙ouble dip鈥� in values caused by falling rents. Some even predict a 鈥榯riple dip鈥� by the end of 2008 if the UK economy slides into recession. Lehman鈥檚 Prew expects City rents to drop by 15% over 2008/09 鈥� and he is not alone. In a note entitled 鈥楰eep the tin hats on,鈥� HSBC real estate analyst John Fraser-Andrews predicts a 9% fall in City rents this year, followed by further 5% falls in 2009 and 2010.

This correlates with Morgan Stanley analyst Martin Allen, who says he anticipates a 23% 鈥榩eak to trough鈥� fall in City rents.

CB Richard Ellis believes City rents have already fallen by 10% from their peak last year. Deputy chairman Stephen Hubbard says prime space commands 拢57/sq ft including incentives, down from 拢65/sq ft in 2007.

Hubbard fears City rents will fall by a further 10% this year and then stagnate for a further two years as oversupply is gradually reduced, returning to growth only by the end of 2010. No prizes for guessing that quoted property companies with exposure to office development in the Square Mile have seen their share prices sink through the floor. Over the past 12 months, British Land has lost 44% of its value, Hammerson 38%, and Land Securities 23%. However, the biggest casualty is Minerva, which has shed 77% 鈥� until takeover talks began.

Dicing with debt

The City may bear the scars of the market鈥檚 worst excesses for years to come, but the whole property industry is set to suffer from a national unwillingness to finance new development. Lending to commercial property has prospered in line with the commercial mortgage-backed securities (CMBS) market 鈥� the financial 鈥榮licing and dicing鈥� of debt, which is sold off in smaller packages to multiple creditors (see graphs).

Jones Lang LaSalle data show that in 2006, there were 鈧�75bn of CBMS transactions across Europe, 鈧�20bn from the UK. This growth correlates with the huge rise in lending to commercial property, which hit a peak of 拢200bn in the UK last year. But in autumn 2007, the CMBS market stopped dead.

鈥楤anks had syndicated loans in this way to recycle cash on their balance sheets, but the current liquidity crisis means they are unwilling to borrow from each other,鈥� explains Barry Osilaja, director at Jones Lang LaSalle Corporate Finance.

鈥楻elationship lending鈥� is the acceptable term for banking paranoia.

Speculative development and job losses in the City of London could lead to the equivalent of 23 empty 鈥楪herkins鈥�

鈥榃hat little cash the banks have, they reserve for their best clients,鈥� says Osilaja. Set against a backdrop of huge losses, writedowns and rights issues, when the banks have recovered sufficiently to lend to property again, the cost of debt will soar and loan-to-value rates will fall.

鈥楩aced with having to inject more equity into deals, office developers are more likely to line up a prelet before schemes proceed.

鈥楲arger deals are already much more difficult to do,鈥� Osilaja adds. 鈥楳ost banks will only allow a maximum of 拢35m to 拢40m for each transaction. Bigger lot sizes demand a 鈥渃lub deal鈥�, which means deals are more cumbersome and take longer.鈥�

The constriction of debt finance could be good news for the City, as the supply pipeline from 2010 onwards has been virtually turned off.

Vultures circle

Meanwhile, back in 2008, quarter one statistics show the impact on the UK鈥檚 office investment market has been nothing short of catastrophic.

鈥楾otal UK investment turnover was 拢6.4bn in the first quarter of 2008, compared with 拢16bn in the first quarter of 2006 and 拢14bn in the first quarter of 2007,鈥� reports Julian Stocks, Jones Lang LaSalle鈥檚 head of capital markets.

鈥楨ncouragingly, the first-quarter figures are slightly up on the last quarter of 2007, which totalled 拢6.1bn.鈥�

Stocks estimates that the UK will end the year on 拢20bn 鈥� compared with 拢50bn last year 鈥� largely driven by sovereign wealth funds and growing numbers of so-called vulture funds, whose strategy is to snap up distressed assets on the cheap.

鈥楢ll investment categories in London are holding up more strongly than shopping centres or national offices at present,鈥� Stocks says, noting that Middle Eastern investors have been particularly active.

鈥楾here is significant firepower sitting on the sidelines, and London is still seen as a safe haven for investors. Opportunity funds worth more than 拢2.5bn have already been raised just for the UK.鈥�

But the scarcity of debt finance to augment this equity may yet clip the vultures鈥� wings.

Another trend is office investment in riskier locations overseas. A year ago, 8% yields on office schemes in Turkey might have looked attractive. Given that UK yields are now 6%-7% on a risk-adjusted basis, investors could beat a retreat to home soil.

Finally, let us not forget the serviced office sector. True, economic uncertainty means that flexibility is at the forefront of occupiers鈥� minds right now. But with conventional landlords liable to offer bigger incentives on ever-shorter leases, the gap is closing. In a deflationary rent environment, operating margins for the likes of Regus and MWB will come under pressure.

Add the chequered outlook for regional offices, and it seems that no corner of the UK鈥檚 office market can be considered 鈥榬ecession proof鈥�.