THE news that part of the London's Treasury headquarters in Whitehall could be converted into luxury flats will come as no surprise to developers at the sharp end of the property market in the city.

From Hackney in the east to Wandsworth in the west, former commercial properties are being snapped up and turned into residential accommodation. The Treasury would simply take this trend to a new pinnacle.

At the luxury end of the market, buildings such as Peninsula Heights, a former 1960s office tower on Albert Embankment, facing the palace of Westminster, has been successfully converted into luxury apartments.

On the fringes of the West End and the City there is also a wave of conversions into loft-style flats which appeal to a new generation of UK homebuyers.

The trend was sparked by the mass of speculative office development which swept central London in the late 1980s and the subsequent slump in property values.

Commercial developers were left with empty buildings and no immediate prospect of finding commercial tenants. Values fell to a level where residential conversions made sense.

"A couple of years ago, it was possible to pick up office buildings in the inner London boroughs for £10 a square foot or less. With shell apartments selling for more than £100 a square foot there was a clear margin for developers," says Mr Ian Lerner of Ian Lerner & Co, a property agent based in Smithfield in the City.

He calculates that about three million square feet of office space in inner and central London has been acquired by developers for conversion to flats.

It is questionable whether even this pipeline of developments will be sufficient to meet demand for housing in central London.

The London Planning Advisory Committee, set up by local authorities, estimates that 150,000 new homes will be required over the next decade in the 11 central London boroughs.

In a recent research paper, Geoff March, of London Residential Research, estimated that about 10,000 homes will be completed in each of the next two years and that supply could diminish thereafter.

Demand for inner London homes is being driven by a number of factors. The increasing rate of household formation - especially the tendency of people to live alone - is a factor boosting demand across the UK.

Mr Marsh also identifies an increased interest in city centre life-styles related to London's increasing role as a world centre of arts and entertainment.

If these forecasts prove correct, residential property values in central London could increase significantly over the next few years as demand outstrips supply.

While this prospect is likely to attract more residential developers into the conversion market, Mr Marsh warns that the market balance varies between boroughs.

Areas where the office market is still weak - such as Clerkenwell, Victoria and Docklands - could suffer from a glut [of residential conversions and are vulnerable to over-supply.

Location will probably become much more important in these districts, with poorly located developments struggling to find buyers.

There are better prospects for residential developers in areas such as Hammersmith, Fulham, Soho and Bloomsbury. The snag is that there are few buildings suitable for conversion.

Most 1960s and 1970s office buildings do not lend themselves to conversion into flats. The floors are usually long and thin making them difficult to divide. The success of warehouse conversions is mainly due to the large open floors enabling developers to squeeze a number of flats on to each level.

If Mr Marsh is right, however, residential conversions may become a permanent feature of London's commercial property market even though the office market is recovering.

Office property values are on an upward trend, but residential developers will also be able to ask higher prices for their flats as demand for housing exceeds supply. There is no doubt, though, that values are being bid higher by competition between developers.

Against this background there must be a risk that mass market developers will see margins squeezed. But it seems unlikely the developer of the Treasury site would suffer such a fate if the residential option is chosen.

Location is even more important to buyers of luxury apartments than in the mass market. Facing St James's Park and with views of Buckingham Palace, the Treasury is sitting on one of the most desirable plots in central London.