Singapore property stocks have had a strong run, and valuations factor in optimistic scenarios, including a 15-25% rise in residential prices, a bottom in Singapore office rents and falling cap rates. While the market’s chase for beta will keep property in flavour, we see upside becoming limited, especially until the office or residential rent outlook improves. The office sector is now key for valuation upside, and the outlook there has yet to improve. We remain negative on City Developments and CCT.

Good run in stocks, on improved residential take-up. The Singapore property stock index has risen 73% since March, led by higher home sales. The market has swung from anticipating large defaults by home owners to expecting significant rises in home prices. We remain of the view that Singapore home prices have seen the bottom, and that 2009 primary transaction volume will come to 8,000-9,000 units. This demand can, intermittently, drive home prices up, but a sustained price escalation needs to be supported by a rising rent environment that has yet to manifest.

What are the stocks factoring in? Based on our analysis, we believe current share prices are now factoring a 15-25% recovery in Singapore residential prices. Furthermore, the expectation appears to be that Singapore office rents will cease to fall from current levels (down 45% peak-to-trough) and that Grade A commercial cap rates will drop 100bps to 4.5% (mid-cycle levels). These expectations seem optimistic, more so those related to a recovery in the office rent market.

Bullish scenario provides limited upside. Even in the tremendously bullish scenario of Singapore/China residential prices reaching historical peak levels and hotel business valuations recovering to mid-cycle levels, the upside for City Developments’ (CIT SP - S$10.00 - U-PF) stock is less than 20% and for CapitaLand (CAPL SP - S$3.93 - BUY) is 25%. We believe the probability of this bullish scenario panning out is rather distant, and upside is becoming restricted in our view.

Office outlook becoming key. Improvement in the office market’s outlook will now be the key driver of any further valuation upside for Singapore stocks. Our recent checks on the office market suggest that office rents are still moving down and that tenants are not committing to new space. Furthermore, the arrival of new physical office space supply in 2H09 will lead to more discounting on office rents. We would avoid office-centric stocks such as City Developments and CCT (CCT SP - S$1.00 - U-PF).