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Understanding Class A vs. B vs. C Multi Family Real Estate
One of the primary reasons people shy away from investing in commercial real estate is the perception that it is too complicated. Indeed, each deal may include a different product type, property class, and project type.
Commercial real estate, as an asset class, includes many different product types including multi family, office, industrial, hospitality, retail, land development and more.
Each of these product types can be further characterized by property class (Class A, B, or C), depending on the age, location, condition and amenities the property offers.
Then there’s another layer to add in, which is referred to as the project type. There are generally five project types:
- Core (stabilized, cash-flowing properties that are typically located in primary markets)
- Core-Plus (underperforming properties located in primary or secondary markets)
- Value-Add (properties ripe for renovation or stabilization, located in primary, secondary or tertiary markets)
- Opportunistic (one of the riskiest project types as these have little to no existing cash flow)
- Ground-Up Development (developing land into any product type).
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For a novice investor, trying to make sense of these nuances can be overwhelming. Which product type, what asset class, or what project type is best to invest in? There’s no right or wrong answer – it depends entirely on a person’s risk tolerance, investment horizon and overarching investment goals.
Some sponsors will focus on investing in Class B / C, Multi Family Value-Add opportunities, maximizing investor returns by renovating these properties to one class higher than when acquired. Other sponsors will engage in the same strategy but by converting Class B properties into Class A, etc.
In this article, we walk you through a basic multi family real estate investment analysis, and look at the distinguishing characteristics of Class A vs. Class B. vs. Class C real estate. Any prospective investor should understand the differences between these asset classes prior to investing in a deal. Read on to learn more.
What is Multi-Family Real Estate?
Simply stated, "multi-family" real estate means "apartments" but the definition goes further than just that. Many people think of “commercial real estate” as office buildings, retail properties and the like. Not all realize that housing can fall within that bucket, as well. Multi-family housing is one such example, with seniors housing and student housing being two other examples.
Multi-family real estate is a specific commercial real estate product type. The term “multi-family” is generally used to differentiate this type of housing from single family homes, condominiums, townhouses and other housing types that are generally owned by one person for use by one household.
Multi-family real estate can take many forms. The simplest form of multi-family housing is a two-unit (e.g., a duplex), in which there are two apartments within the same building, under the same roof, generally sharing common systems such as the HVAC, plumbing and electrical (though these systems can be individually metered with costs charged back to the tenants) and always sharing either common walls, either vertical (side-by-side) or horizontal (for up-and-down units).
Many first-time investors will buy a small multi family property, such as a duplex or four-family home, that they owner-occupy initially while renting out the other unit(s). One of the benefits to doing so is the owner can obtain the most favorable bank financing when owner-occupying the property. It also allows a first-time investor to learn the “lay of the land” when first becoming a landlord.
Multi-family can be much broader than that, though. For example, large apartment complexes can easily have 200+ units across multiple buildings with or without several on-site amenities. Larger multi-family apartment buildings, especially downtown high rises, are usually purchased and operated by more sophisticated investors, such as life insurance companies and pension funds.
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What Is an Asset Class?
An asset class is a group of investments that have similar characteristics, and therefore behave similarly in the marketplace. Equities, such as stocks, bonds, and money markets are considered the three “traditional” asset classes. Real estate and commodities are two additional asset classes, sometimes referred to as “alternative investments” – though both are increasingly entering the mainstream.
People often refer to commercial real estate "asset classes" to distinguish between different types of properties. What they’re really doing however, is differentiating among property class: Class A, Class B, and Class C. That’s because real estate itself is the asset class, and within that asset class, there are different property classes. Confusing, yes, but an important distinction to make.
The “Class” system in real estate was created as a way of simply conveying the characteristics of a potential real estate investment. The Classes – A, B, and C – are based on a combination of physical, geographic and demographic characteristics. Each class represents a different level of risk and return.
What Are the Different Types of Multi-family Property Classes?
As noted above, there are three primary “classes” of multi-family real estate: Class A, Class B, and Class C. We’ll break down each of these in more detail below, but in short, Class A tends to be the nicest (and most expensive) of the bunch with more amenities, situated in better locations, and catering to a higher credit rated tenant. Class C properties tend to be older, have fewer amenities, are less well located, and are most likely in need of renovation. Class B multi family properties fall somewhere in between.
There are pros and cons to investing in each multi family class type. For example, Class C properties tend to be the most affordable and therefore, the most accessible to everyday investors looking to own commercial real estate. These are, however, the most vulnerable to market downturns, such as happened during the Coronavirus pandemic, when unemployment skyrocketed and those who felt the impact of this the most those working tenants who reside in Class C properties.
Class C properties can be diamonds in the rough with significant necessary physical upgrades, or upgrades to ongoing business operations like management and marketing. As housing and property values continue to climb in many parts of the United States, Class C properties are becoming a hot commodity in the world of multifamily development.
Class B properties often have great bones, but have suffered from neglect and simply need a renovation to be brought into Class A status or otherwise to raise their rents to market levels. Meanwhile, Class A properties tend to be occupied by residents with steadier jobs and higher credit scores. The larger Class A properties are also more likely than other asset class to attract institutional buyers providing deeper pocketed exits for sponsors and investors.
Class A Multifamily
Class A multifamily investment properties are generally considered one of the “safest” investments from a risk perspective. One of the reasons for that is Class A properties are usually well-located in primary markets, and in areas where the underlying economics are strong. These properties tend to be located near major employers, universities, hospitals and arts and cultural activities. They will usually have good access to highways and/or public transit. In other words, these are considered “safe” investment opportunities because Class A multifamily buildings are located in areas where people generally want to live.
Another distinguishing factor among Class A properties is their condition. Many Class A buildings are newly constructed and feature high-end finishes and abundant tenant amenities, but this is not always the case. A property need not be new to be considered Class A. An older building, perhaps an historic property, that has been gut renovated and fully rehabbed in line with new construction can just as easily classify as Class A.
Class A properties, given their location, condition and amenities, usually command high rents, and as a result, strong cash flow. These properties will usually be in high demand amongst a broad range of investors, including institutional and foreign investors, which can drive prices beyond the means of the average investor. Class A properties, given robust demand, are usually equally as easy to sell even amid ebbs and flows in the market.
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Class B Multifamily
Class B multifamily properties are a step below Class A properties. They tend to be slightly older or in less pristine condition. They might be located on the fringe of a primary market, such as a submarket on the outskirts of a downtown.
Maintenance costs at Class B properties are typically higher than at Class A properties, which is something diligent investors will want to factor into their pro forma prior to investing. Class B multifamily properties may be in need of light renovation, common area improvements, system replacement, or new facades or landscaping upgrades. Most Class B properties will have high-quality, if not professional third-party management.
Class B properties typically have fewer amenities (e.g., on-site fitness centers, doggy daycares, storage lockers, covered parking, movie rooms, outdoor pools) than their Class A counterparts, and as such, will usually command lower rents. That said, these properties still tend to attract quality, stable tenants even if overall building vacancy tends to tick higher than what would be expected at Class A buildings.
Class C Multifamily
Class C buildings can be lucrative for those with a solid investment strategy, but these properties are certainly not without their risk. In fact, Class C properties are considered the riskiest of the three property classes featured here today.
One of the reasons for the additional risk is that these buildings are generally older (20+ years) and in need of significant renovation. Many will show visible signs of deterioration, such as overgrown landscaping or crumbling building facades. These properties, because they are older, will usually include few, if any, on-site amenities.
They’re typically older buildings, often more than 30 years old with few recent modernizations/renovations and original appliances, wiring, plumbing, etc. Many Class C properties are in poor physical shape and suffer from significant structural/livability issues caused by insufficient or inadequate maintenance schedules.
Class C properties often sit in lower-income neighborhoods in less desirable locations. Crime rates tend to be higher in these areas, and regional infrastructure like schools, employment opportunities, and amenities often lags behind more desirable markets.
Due to the above-mentioned issues, Class C properties tend to be underpriced compared to Class B and Class A properties. Keep in mind that many if not most Class C properties will require substantial upfront costs to bring the property into good standing, these costs include renovations and physical maintenance, as well as administration and management issues like marketing the property, finding new tenants, and so on.
Compounding the risk is the fact that Class C multifamily buildings tend to be located in less desirable locations. They may be farther from major employment centers and/or in areas with high crime and few neighborhood amenities (e.g., grocery stores, pharmacies, restaurants, parks and playgrounds). Often, those who live in Class C buildings do so only because they are more affordable than the alternatives.
Class C properties tend to be riskier for several reasons, namely that they sit in less economically developed areas, involve tenants with somewhat unstable financial situations, and they are often capital intensive to start-up where delinquencies, higher crime rates, or increased vacancies caused by undesirable tenants can introduce unwanted risk into a project.
This doesn't mean that they cannot be fantastic investments, it just means that when investing in Class C properties, investors need to tread deliberately and bring all of their combined experience to ensure the project is a success, which brings us to our next point.
Class C properties, however, offer the potential for the highest cash flow out of these three property classes. This cash flow is hard earned, as these buildings are often management intensive.
Some properties will not be able to cash flow upon acquisition and will require some downtime to undertake renovations. This will delay income from the property, and investors in Class C properties should be prepared for this inevitability and count it in their financial predictions.
What Factors Affect Property Classification?
There are several factors that affect a property’s classification, including location, the age of a building, property condition, amenities and occupancy. These factors should be considered generalizations, as there are almost always exceptions to each of the “rules” below.
A property’s location is one of the biggest driving factors of its classification. As noted above, Class A properties tend to be the most well-located. These properties will have easy access to major employers, hospitals, universities, and arts and cultural amenities including retail and restaurants. They will usually (but not always) be located in areas with good school districts and low crime.
The reason for this caveat is because some Class A properties are located in highly desirable urban locations where the school districts might otherwise be inferior to some of their suburban counterparts. That said, many of those who live in Class A multifamily buildings will sacrifice school district for location, opting to send their children to private or charter schools instead.
Class B and Class C properties are generally in less desirable neighborhoods. For instance, Class C properties often sit in lower-income neighborhoods in less desirable locations. Crime rates tend to be higher in these areas, and regional infrastructure like schools, employment opportunities, and amenities often lags behind more attractive markets.
However, this is not always the case. A Class B or Class C property – whose classification is instead driven by its age, condition or lack of amenities – may have an excellent location but the building itself otherwise leaves much to be desired.
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Age of Building
The age of a multi family property will also influence its classification. Class A buildings tend to be newer (often, new construction), whereas Class B and Class C properties are usually older. Class C properties will usually be 20-30+ years old.
However, another exception to this “rule.” An older building, such as a historic property, can still earn Class A status if it meets the other criteria listed here. Older buildings are often gut renovated to include high-end finishes and other amenities akin to their newly-constructed peers. Age alone cannot determine a property’s class; it must be considered alongside the other factors.
A property’s condition is one of the leading factors of its class. A property that has been fully renovated and upgraded with high-end finishes is more likely to achieve Class A status than a multi family property that is old, weathered and in need of both cosmetic and structural repairs. As a result of property condition, Class A and B properties tend to need less maintenance than Class C buildings.
Class A properties will usually offer robust amenities. In the realm of multi family commercial real estate, this could mean an on-site fitness center, media room, concierge, underground or otherwise covered parking, outdoor pool, doggy daycare and more. The larger the apartment community, the more robust the amenities will tend to be. Class B and Class C properties usually have fewer, if any, amenities to offer residents.
Occupancy is a key factor in property class. Class A properties tend to attract the most attractive tenants: typically high-income earning professionals with high credit scores. Class A buildings appeal to the masses, and therefore, will usually have very low vacancy. Class B and C properties usually have less desirable tenants (typically, people who earn less and with lower credit ratings) and may have more variable occupancy levels.
Of course, there are exceptions to this rule as well. Class B and Class C properties may also attract high-income earning professionals who are more cost-conscious than their peers. Often, people will rent more affordable Class B and Class C apartments while trying to save for a down payment on their own home.
Other Factors to Consider
Residential Rental Property Types
We touched upon this briefly above, but let’s elaborate: there’s a distinction to be made between “residential” rental property and “commercial” multi-family property. Residential rental property types include 1-4 unit rentals, including single family homes, condos and townhouses that are purchased by an individual and then rented to someone else.
These 1-4 unit properties do not fall within the same category of multi-family housing as the commercial product types discussed here today because they are classified for lending purposes as all being in the same category as single family properties.
Therefore, although properties with two to four units fall within the multi-family classification, because as the name would imply, there are multiple apartments within a single building, buildings with four or fewer units are generally considered “residential” rental properties because they are eligible for residential bank financing.
Properties with five or more units are considered “commercial” properties, and therefore, must obtain commercial debt. The terms for residential debt are typically more favorable than the terms for commercial debt, the latter generally being at least 50 basis points higher than the rates quoted for residential properties.
What are the Risks of Investing in Each Category?
As is the case with any investment, real estate-related or not, there are risks associated with investing in each “class” of multi-family real estate, including:
- Class A: One of the biggest risk with investing in Class A is one of oversupply.
As the market strengthens during real estate cycles, the price of land increases as do construction costs. As land values increase, the only way to make deals 'pencil' is to underwrite them to ever increasing rents which typically means assuming they will yield Class A type rents.
This in turn means that developers find themselves needing to build only Class A apartment buildings to stay in business as developers. This leads to oversupply and associated rent depreciation when markets turn down.
There’s also risk during boom times- as luxury tenants often have the ability to purchase their own housing and not rent, when times are good you run the risk of playing second fiddle to growing housing prices. We’ve seen a bit of this happening during the recent COVID-19 pandemic, as luxury apartments in dense urban areas sit vacant while well-heeled renters fled to the suburbs.
- Class B: One risk associated with investing in Class B real estate is the threat of competition.
If an influx of new, Class A multi family housing hits the market, the existing Class A inventory might be pushed into the Class B category, thereby creating increased competition for Class B housing. A secondary risk of investing in Class B multi family is not having the resources needed to maintain the property as it ages, and/or to execute the investors’ business plan to bring the property into Class A status, if that was ever the intention.
Some of this risk can be mitigated with the right location, but at the end of the day, you’ve got to be able to attract the right tenants- without the benefit of the very best amenities or the choicest location- that can be capital and time intensive, and a bit daunting when you’re not looking at the same gains from forced appreciation that you might see from a Class C property, or the highest quality tenants like you might find with a Class A property.
- Class C: The largest two risks to investing in Class C real estate is the cost of repairs and maintenance over time, and the lower credit and employment stability of tenants.
These buildings tend to need the most work and are at risk of becoming functionally obsolete if the owner does not make the necessary investments. The second risk to investing in Class C multi family, the quality of the tenant pool which tends to be lower income and potentially at highest risk of non-payment of rent (and therefore, eviction), can be particularly badly pronounced during economic downturns.
Tenants in Class C buildings tend to be lower paid workers who are more vulnerable to layoffs when the overall economy goes into recession. Class C properties command lower rents than similarly appointed Class B properties and won’t have the same kind of amenities as either Class A or B properties.
Many times, new investors in Class C properties have trouble with forced appreciation of a property. Forced appreciation refers to the steps individual investors take to improve the value of the property--things like renovations, business plan implementation, more effective marketing, reducing vacancies, etc. This is in contrast to natural appreciation, which is the rate at which the property appreciates in value based on market forces.
Managing any Class of property has challenges, but managing a Class C project on your own can be an incredibly time-intensive process. Investors who want to benefit from the high returns offered by Class C properties, but do not have the time or desire to get in the trenches themselves can work with professional management to take care of the heavy lifting. Even so, a competent owner will not rely entirely on a third party management company to control a property but will be active to some extent, especially where it comes to identifying areas for property improvement and security.
What are the Potential Benefits of Investing in Each Category?
We’ve touted several benefits of investing in multi-family real estate in general, but there are specific benefits to investing in each property class, including:
- Class A: These properties are generally the nicest and newest of the bunch, and therefore tend to need less maintenance.
Class A multi family also tends to attract the most desirable renters, such as six-figure earners and long-term tenants willing to pay a premium to live in these attractive properties.
Since you’re dealing with more discerning tenants, appliances, fixtures, and building features will be newer when purchasing a Class A property, so repair and replacement bills will be smaller- at least at first.Since Class A properties tend to sit in desirable areas, much of your initial due diligence is already done- at least as far as scoping out the area.
Expect these properties to sit in areas with good access to transportation, whether that be in the form of walkable neighborhoods, proximity to job centers, or being close to shopping and retail areas.In addition, when (or if) the time comes to sell- you’ll likely have a much larger pool of buyers looking to acquire the property- many investors ignore B and C properties to focus solely on Class A, either they don’t want the additional risk, or the necessary work to generate potentially higher returns- either way, it makes your life easier when it comes time to sell.
- Class B: The primary benefit to investing in Class B real estate is that these properties tend to be highly durable throughout economic cycles.
In an upmarket, Class B multifamily attracts a diverse pool of renters – both those who could afford Class A real estate but are more cost conscious, as well as those who earn less but are willing to splurge on the amenities included in a Class B property. In a down market, Class A renters will often vacate their units and move into Class B properties as a way of saving money.
Another benefit of Class B real estate is that, if well located, the property can often be brought into Class A condition through thoughtful renovations. Class B properties tend to be between 10-20 years, although this is not a hard and fast rule. Class A properties will typically become Class B properties after a certain period of time, unless consistent renovation and renewal is undertaken at the property- the cycle usually goes Class A to Class B to Class C, although again, this is not set in stone.
These properties are well maintained, with few deferred maintenance issues. Finishings and fixtures on the property tend to be above average, but usually not brand spanking new. They sit in neighborhoods that are mostly middle or working class, with above average school districts and fairly low crime rates. All of these factors add up to a sort of “Goldilocks Effect” where you get many of the benefits of Class A, without the premium price tag
- Class C: The biggest draw of Class C multi family is its price point, as it is the most affordable of the property classes and therefore, appeals to the broadest range of investors.
First and foremost, Class C properties are often available for bargain prices, which can be a godsend in many high cost of living urban areas where prices have grown out of the reach of many investors.
This means investors can acquire more properties with the potential of generating higher cash flow than other classes of apartment building.As Class C properties are usually value-add opportunities, with low acquisition costs and high potential to improve profitability, investors can generate more cash flow from a Class C property than for another property class with higher acquisition, upkeep, and management costs.
Class C properties possess lower acquisition costs means that it can be easier to benefit from the economies of scale with a Class C property portfolio.They often have the potential to benefit from forced appreciation, which is when investors and developers add value to a project to increase cash flow, decrease vacancy, and so increase the total value of a given property. There is usually more room for adding value with a Class C property because, provided the neighborhood can tolerate the upgrade, they can be improved to Class B or even Class A properties, whereas Class A properties typically have relatively little upward potential and are most often purchased strictly for yield.
Since Class C properties have lower acquisition costs than similarly featured buildings in Classes A, and B and operational costs can be higher due to the extra layers of management often required to keep a Class C building stabilized.This can dampen relative returns but overall, Class C properties are less desirable to investors – certainly of little or no interest to institutional investors – so cap rates are generally higher meaning yields to investors are going to be higher.
They have greater potential for improvement in both rental rates and occupancy levels so the opportunity to increase capital gains can be more pronounced than in Class B or Class A where there may be less potential to add value.Someone looking to invest in multi family for the first time might start by investing in Class C. They can improve the property over time, perhaps bringing into Class A or B condition, and then sell the property for a profit – profits that can then be reinvested in a nicer, newer multi family property if the investor so chooses.
Can a Property Class Change?
A property’s class can certainly change. In fact, there are investors that deliberately invest in Class B and Class C value-add multifamily apartment buildings with the intention of heavily renovating the properties to Class A condition. For example, a Class B property may be exceptionally well-located but under the current ownership, suffers from significant deferred maintenance. A little TLC (and major capital investment) could potentially bring this property in line with Class A standards.
Remember: property classes are really intended to be a guide. Property class is heavily influenced by the properties in the area.
Let’s use the example of a 250-unit apartment building constructed in downtown Los Angeles in 2014. That building may have been considered a trophy asset for most investors. But in recent years, there has been an influx of new apartment construction in Los Angeles. Now, that 250-unit property has significant competition.
Its competition is newer, has more modern amenities, and appeals to a broader subset of the population. People start moving out of the 2014 building in favor of the shiny new towers nearby. The 250-unit property, once considered Class A, may now be considered Class B in its area among investors. With a simple refresh, the property could be brought back in line with its latest competition.
Which Property Classification Is Best for Your Portfolio?
Wondering which property class to invest in? You aren’t alone. As indicated above, adding properties to your portfolio should really be based on your individual risk tolerance. Class A buildings are inherently “safer” investments than Class B or Class C properties.
It is tempting to buy a Class B or C building with the intention of renovating the building to Class A standards, but this is no small order. Only the most adept investors (or those who have partnered with highly experienced real estate developers) should pursue this strategy, as it carries must more risk and potentially, higher upfront capital contributions.
That said, those who have a solid roadmap to property improvement and stabilization will find that Class B and C properties generally trade at higher cap rates and therefore, generate higher returns than Class A buildings.
When looking at various investment opportunities, be sure to consider the property’s location. The property’s location is one of the only key drivers of classification that cannot be changed. You can renovate a property, add amenities, and drive occupancy – but you can never change a property’s location.
Top Multi-family Real Estate Markets
There are many ways to define the “top” markets for multi-family real estate. For example, some investors might evaluate markets based on an area’s growth potential over time. Others may consider the cap rates within a specific market.
Even those looking at cap rates may have differing views as to what’s a “top” market. Some investors may look at markets with low cap rates (3-5% on multi-family housing) as being the most attractive places to invest, as these areas tend to be established and have high rents (but as a result, high purchase prices and by extension, high barriers to entry). Meanwhile, other investors may prefer markets with high cap rates (10%+) as that can signal an opportunity for investors to deploy value-add strategies.
Deciphering “top” markets largely depends on a person’s investment strategy. Those with a long-term, buy and hold philosophy may view market opportunities differently than those with a shorter-term, value-add mentality.
In any event, here are some of the top markets today based on a combination of factors.
For several years now, Austin, TX has been considered a darling of the multi-family real estate sector. The metro area continues to grow, with robust employment growth and new household formation. This has kept demand for multi-family housing strong across all property class types. Multi-family housing in Austin tends to be relatively affordable compared to other markets, yet it continues to command strong rents from a broad tenant mix.
Atlanta is another market that continues to grow, and therefore, multi-family demand remains strong. This is true in both downtown Atlanta as well as the surrounding suburbs. The diversity of Atlanta’s neighborhoods makes it attractive to those looking to invest in Class A high-rise buildings as well as smaller, garden-style apartment communities in the adjacent suburbs.
Like Austin and Atlanta, Phoenix is considered one of the top markets for multi-family housing given the region’s continued economic growth. Hundreds of new residents are moving to the state each day to take advantage of new job opportunities. That said, new multi-family housing construction has not kept up with demand and therefore, there’s pent up demand for rental housing which is driving prices higher.
Boston may surprise some readers, but according to CBRE, a national real estate advisory firm, Boston continues to be one of the top markets for multi family housing. Boston’s population is not growing like the markets described above, but the region benefits from world-renowned hospitals and universities that make the economy more recession-proof than other markets. The area is also land-constrained, making new multi-family housing development a challenge. As such, existing rental properties tend to hold their value despite swings in market conditions.
Arlington is now on the radar of all multi-family real estate investors thanks, in large part, to Amazon’s announcement that it would be bringing it’s “HQ2” headquarters to Crystal City, a neighborhood within Arlington. This is expected to create thousands, if not tens of thousands, of new jobs for the region – a region already in desperate need of additional multi-family housing.
Commercial real estate has always been a difficult asset class for individual investors to access for many reasons. The primary reason is its capitally intensive nature: oftentimes, you need significant capital outlays to be part of a real estate project. Accredited investors can increasingly partner with companies who crowdfund their syndications, pooling capital and then deploy resources in a portfolio of real estate assets. This approach is attractive to investors who are unable or unwilling to invest in commercial real estate individually.
But investors should not blindly invest with third parties.
Instead, prospective investors should carefully consider both (a) the experience of their investment partner in terms of not just the number of years they have been in real estate, but how many downturns they have weathered; and (b) their partner’s investment strategy, be it ground up, value add, core or core-plus (c) transactional experience in dollar terms; the greater the better and, (d) the terms of the deal and the alignment of interest between the sponsor and their investors.
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