Local and foreign retailers that are expanding into second-tier mainland cities could suffer a decline in profitability as the spending power in those markets lags far behind gateway cities, McKinsey & Co has warned. Although start-up costs for a retail outlet in second-tier cities are 30 per cent lower than the expenses in prime cities, sales are on average 45 per cent less than in bigger cities, according to a recent study by the consultancy firm. Many foreign retailers, including Wal-Mart Stores, Tesco and Carrefour, are branching out into smaller mainland cities, betting that the expansion would benefit from the country's fast retail sales growth. The Ministry of Commerce forecasts the country's retail sales to grow 13.2 per cent this year to 8.6 trillion yuan. Retail sales in the first two months this year rose 14.7 per cent compared with a year earlier, the National Bureau of Statistics said. Some Hong Kong-listed retailers are also investing heavily in tier-two cities to drive growth as the market in key cities such as Beijing and Shanghai become more competitive. Lifestyle International, which operates two Sogo stores in Hong Kong, has announced department store projects in Dalian, Tianjin, Qingdao, Harbin, Shenyang and Suzhou since December last year. Investment for these projects exceeds two billion yuan. Gome Electrical Appliances Holding, the mainland's largest consumer electronics retailer, will step up expansion in tier-two and tier-three cities and expect them to be its long-term growth driver. However, according to a Credit Suisse study released in March, the average monthly household income in four tier-one cities - Beijing, Shanghai, Guangzhou and Shenzhen - was 6,070 yuan last year, while the measure for four tier-two cities - Shenyang, Wuhan, Chengdu and Xian - was 4,060 yuan. The Credit Suisse study also found that residents in second-tier cities used up to 31 per cent of their income as savings, higher than the 26 per cent in the largest cities. The McKinsey report did not give detailed figures on income or spending. Apart from less spending power, retailers in second-tier cities, especially in eastern regions, were facing surging real estate prices, said Richard Cheung, a principal at McKinsey. Some of these cities, including Hangzhou, saw double-digit gains in property prices every year, Mr Cheung said. 'You can see real estate prices in these cities rising much faster than consumer income growth and consumer product prices.' He said that foreign hypermarket operators performed better than their local rivals as some provided bus services for customers without cars. The McKinsey study found 7 per cent of China's retail sales came from hypermarkets in 2005, up from 3 per cent in 2003 and 2 per cent in 2001. About 25 per cent of the sales came from supermarkets in 2005, up from 23 per cent in 2003 and 15 per cent in 2001.