Should you invest in a tier-2 city?

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Fundamentals of real estate investments remain same whether you are planning to invest in tier-1 or tier-2 cities. I believe Tier-1 cities are like large cap stocks and Tier-2 cities are like Mid-caps. Large caps gives you marginal but stable returns while Mid-caps provide the opportunity to generate higher returns & hence are inherently riskier compared to Large caps. Just the way you evaluate a large cap stock, you also evaluate Mid-cap stock on same parameters. (You can read about the best principles of real estate investment here.)
Why Invest in Tier-2 Cities
If you want to invest, always invest in a city which is either very close to your current residence or a place where you have relatives & friends to fall back on. Primary reasons for investing in tier-2 cities should be:
1) Growth Potential: Prices of properties in tier-2 cities are much lower than those of tier-1 cities. Hence, you can buy more properties for the same value of money. Additionally and “hopefully” the lower prices may provide opportunity for higher price appreciation in future.
2) Diversification: You can buy a different asset class in tier-2 city. For example – you may not be able to buy a rent yielding retail or commercial property in tier-1 city because they are way too expensive. However, for similar returns you can buy such commercial properties at fraction of cost in tier-2 cities. Also, constructed properties are much safer than lands with respect to illegal encroachment or grabbing.
3) Industrialization of Tier-2 City: Property prices have become prohibitively expensive in Tier-1 cities. It is next to impossible to set up any large scale industrial complex in tier-1 cities due to lack of availability of lands as well as cost of land acquisition. Most of industrial activities is rapidly shifting to tier-2 cities, primarily to those closer to tier-1 cities. Hence, there would be sustained demand for properties in tier-2 cities for both residential and commercial development. Bangalore is a perfect example of this pattern – Prior to 2000 Bangalore was a sleepy town of retired people. IT revolution of early 2000s transformed this tier-2 city into a bustling metropolis in less than two decades.
What to look for prior to investing in Tier-1 City
Look at the growth potential of the city before investment. Are people migrating from nearby villages and towns to “this city” for better opportunities & infrastructure such as schools, jobs, business and better law & order? If yes, the city has long term growth potential. Look out for below indicators:
1) Industrial activity: Is it a tourist place? Is there any large industrial complex coming up in the town? Are the existing factories expanding? Such developments provide huge boost to real estate in short as well as long term. People who would be working there might look to buy lands for their self use or just for investments. Shops and other commercial developments will start coming up in the vicinity which will give boost to demand for real estate.
2) Social Infrastructure: Ironically India doesn’t have more than 30 to 40 good tier-2 cities with decent infrastructure such as roads, schools, colleges, universities, 24 hr electricity & water availability. People migrate from tier-2 cities to tier-1 cities, from towns to the nearest Tier-1/2 city or from villages to the nearest town / tier-2 city. This is the natural progression for any human society. Make sure your city has decent social infrastructure to sustain the migration of people from nearby areas.
3) Law & Order situation: A large number of people migrate from villages or towns or even one city to another city because of better law & order situation. Bad law & order disrupts the society. No businesses will come up due to poor law & order and hence employment generation would be extremely limited. We all know what happened in Bihar during 15 years of lawlessness under Laloo Yadav’s tenure. Bihar has probably the highest percentage of migrants across India.
Risks of Investing in Tier-2 Cities
Real Estate is very local i.e. it is immovable, has local characteristics, risks and laws. You must know what you are buying and why you are buying a particular property. You must understand the inherent risks of investments and find out whether return on such investment is worth it. Below are the critical risk factors of investing in tier-2 cities:
1) Lack of Transparency
Development Laws are not so clear in tier-2 cities as compared to those of tier-1 cities, which are much more tightly regulated by the govt. and civic agencies. How do you know whether the constructed property has valid approvals? Additionally, it is very difficult to find out the fair market price of properties in tier-2 cities. Guidance value of properties are much lower compared to their market prices. Also hardly any transaction is reported in media or tracked by credible property agencies.
2) Lack of Title ownership
One cannot be sure of title in any part of India, more so in smaller cities and towns. Due-diligence of properties is very risky in such cities. Absence of top legal or credible legal firms in these cities make due-diligence of properties even riskier. Avoid places which are mired in land controversy and disputes at all cost.
3) Poor Law & Order
Tier-2 cities suffer from relatively poor law & order compared to tier-1 cities. If you are not residing in tier-2 cities or do not have relatives / friends to look after your properties, chances of your property getting encroached are very high. It is very difficult to get an unruly tenant evicted from your property in tier-2 cities without the intervention of local authorities. This is especially troublesome when you are not a resident of that city.
4) Cash Market
Compared to tier-1 cities, real estate transaction in tier-2 cities involve much higher cash components, which can be up to 60% of the property value. By cash component I mean unaccounted payments. You must avoid dealing in cash at all cost.
According to 2011 census, population living in urban areas in India was 31.16% compared to that of China’s ~45%. For India this is expected to increase to 41% by 2030. According to a recent Mckinsey study, India’s urban population will grow from 390 million in 2011 to 590 million in 2030. As we are not creating any new city, almost all this additional migration will be to Tier-1 & 2 cities. This means new housing demand from 250 million people in urban centres by 2030!! No matter what you decide, do not forget these two golden rules of investment. Rule #1: Never lose money. Rule #2: Never forget Rule #1.
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