But are they such a great bargain? Many of the Tier 2 cities are turning into money pits, according to a new report from Credit Suisse, and should be avoided.

“We believe the conventional wisdom of favoring developers’ exposure to Tier 2 cities is wrong,” the report, put out March 1, states. “Many of these cities are value traps due to low development margins and an oversupply situation there.”

Developers are basing their construction plans on assumptions that many of the cities in the second tier will turn into mature property markets like Shanghai or Beijing. But that may take years to unfold. In the meantime, they face severe pressure on profits, and will have to compete with a flood of sales.

“Last year, everybody was looking at the second-tier cities as the bright spot, and I was in that camp as well,” Jinsong Du, the head of China property research at Credit Suisse, said. “But are we overstretching ourselves? If you are building things that are only going to be used in 10 years, maybe we have an issue.”

It’s a controversial stance, but one that stems from careful analysis. Land prices are often surging faster than home prices in second-tier cities. That is a trend most dramatically seen in Haikou, where land shot up 93 percent over the prior year, compared with a 45 percent increase for residential property. In Wuhan, land prices were up 28 percent in 2010, while home prices rose only 7 percent.

The Tier 1 cities are normally defined as Shanghai, Beijing, Shenzhen and Guangzhou. New-home prices shot up 35.4 percent last year in Tier 1 cities, to 18,853 yuan ($2,870) per square meter, according to DTZ.

But prices are also rising fast in the Tier 2 cities, normally defined as China’s 23 provincial capitals. DTZ looked at a basket made up of Tianjin, Shenyang, Chengdu, Wuhan, Xiamen and Changsha, and saw their costs for new homes climb significantly, too, up 26.1 percent in 2010. But it is off a lower base, leaving them at 7,015 yuan ($1,070) per square meter.

Starting this year, there’s also the threat of a massive oversupply of new property, as the results of government initiatives to push developers to speed up projects pay off. Developers typically have to start projects within a year or risk losing the land.

That’s boosting supply at a time demand is being suppressed. The State Council, for instance, has ordered 36 cities to impose limits on how many homes families can own. That typically results in families being restricted to owning one home for self-use and another for investment.

“Last year, a lot of investors couldn’t buy in first tier cities, so they went to second tier cities,” Du said. “This year, the government is tightening on second tier cities as well. They no longer enjoy a free ride.”

Beyond restrictions, sentiment is starting to shift a little, Du believes, with many prospective purchasers watching for weakness in the market. That may encourage them to put off purchases. Sales volumes dropped sharply in most cities in February, although prices inched ahead 0.48 percent on average, across 100 cities, according to a report from the China Index Research Institute.

“It’s like any bubble – if everybody believes the property price will keep going up, it is still OK, even though it’s overbuilt,” Du said. But the bubble may be stopping to inflate. “Right now you have an oversupply issue that is much, much more severe than last year, and because of tightening measures people can’t buy.”

Higher costs and restricted demand put pressure on developers’ margins. At times, the situation is so extreme that the margins on new-home sales are negative. According to Credit Suisse calculations, that’s the case in three Chinese cities – Hefei, Chongqing and Changsha – where the net margin is so poor that developers will be losing money on each home they sell.

After land costs of 2,210 yuan per square meter in Hefei, and construction costs of 2,500 yuan, they’re able to achieve an average sales price of only 5,320 yuan per square meter. Throw in financing, marketing and tax expenses, and Hefei homes produced a net profit margin of minus 9 percent. Developers would lose an average of 4 percent in Chongqing and 3 percent in Changsha.

Higher prices are only one side of the equation. Residential land supply has increased dramatically in some cities. In Wuhan, for instance, the land supply rose so quickly over the last three years that there’s now a bulge in the pipeline of new homes equal to eight times the average annual home sales in the city. The backlog is over seven years’ worth of home sales in Dalian, Tianjin and Taiyuan.