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cant say for sure but i upgraded my town to a city pretty much directly after being crowned
You upgrade a town to a city, you need to have 3 towns and the town you want to upgrade has to have 16 buildings (again, the blue pier and lighthouse spaces and the green wall space don't count).
You can upgrade your capital to a city as soon as you annex Varnhold. Up to that point, you'll be able to take over up to 5 other territories, letting you have 2 towns before gaining Varnhold, which comes to you already upgraded to a town.