Should You Invest in a Class C Property?
By Adam Gower Ph.D.
The multifamily real estate sector offers investors a wide array of property types and classes in which to invest. This is one of the more attractive features of commercial real estate and allows investors to choose assets that match their investment goals. For instance, a low cap rate Class A property in a dense urban core may provide more stable returns with less sweat equity, while a high-cap-rate value-add Class B or C property might offer higher yields, for investors who have a bit more room for risk in their portfolio.
Multifamily property classes are categorized based on several different factors, including the age of the property, its location, any special features or amenities, gross income, and others.
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.
What is a Class C Property?
Class C Properties are:
- 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/liveability issues caused by insufficient or inadequate maintenance schedules.
- 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.
- 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.
- 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.
- As many Class C tenants suffer from income insecurity, or on government-provided fixed-incomes, vacancy and turnover rates are usually higher with Class C properties, with more evictions than higher-class properties.
- 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.
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4 Benefits of Investing in a Class C Property
While Class C properties may not be the shining stars of the multifamily world, there are numerous benefits offered by investing in properties like these. Including:
1. Lower Acquisition Cost
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.
2. Higher Cash Flow
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. As we mentioned earlier, lower acquisition costs means that it can be easier to benefit from the economies of scale with a Class C property portfolio.
This might include hiring a property management company to oversee the portfolio, acquiring services like cable or internet for resale to tenants, purchasing renovation or maintenance materials in bulk etc. These all add to cash flow by adding additional revenue streams or reducing costs.
3. Building Relationships in the Real Estate Industry
Acquiring a Class C property is not for those investors looking for an easy side project or quick gains. Renovating and managing Class C properties is usually more management intensive than other classes of apartment buildings due to property characteristics not limited to the neighborhoods in which they are typically located, and the likely state of current rent roll – you may find that a building has high occupancy, for example, but equally high delinquency rates on rents.
Working Class C properties is not unlike working others; it just requires a more intensive approach so finding the sub-contractors who can help you manage them is especially important. This includes a whole host of real estate and finance industry professionals, including brokers, lenders, general contractors, builders, architects, and anyone and everyone related to property renovation and management who is comfortable working at this more challenging end of the apartment quality spectrum.
4. Appreciation Opportunities
For those willing to do the work, Class C properties 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.
Challenges of Investing in a Class C Property
Like every other asset class, there are several challenges associated with Class C properties as an investment asset.
Like any challenge, these too can be mitigated but, before undertaking any investment opportunity, it is essential that you understand the potential upside, as well as potential pitfalls you may face.
Many times, new investors 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.
One of the biggest challenges of Class C properties is that in many cases there are going to be undesirable tenants who can destroy the reputation of a complex and make it unpleasant for other tenants too. Crime rates tend to be higher in and around Class C apartment buildings and calls to emergency services more frequent. These require a certain type of management to handle and going through the process of cleaning up a tenant mix can be time consuming and costly which can slow the appreciation of a building down beyond the pace projected in the business plan.
Management and Maintenance
Once a Class C property has been upgraded and stabilized, continuing management and maintenance is another area that can trip up investors, especially those with little experience managing Class C properties. Their unique challenges, not found as much in other classes, including potentially higher vacancies, damage to apartments, evictions, and other high-stress/high-risk situations, mean ongoing management has to stay on top of allowing a property to regress into its earlier status.
To do this effectively it’s important for owners to stick to the fundamentals of the rental business--always work to reduce risk by carefully screening tenants before they move in, address legitimate tenant requests, and work under the rules and guidelines of local authorities. In Class C properties, additional security, common area lighting, and even security patrols that you may not need in Class A properties, though adding cost to operations, can keep a building tenant friendly with high occupancies and higher rents.
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Class C Properties vs. Class A and B
Now let's take a look at how Class C properties stack up against Class A and Class B properties.
Property Risk Levels
The higher potential returns offered by Class C properties also come with additional risk. Class A and B properties tend to have lower cap rates, which means the expected return for commercial investors will be lower. However, lower returns are generally correlated with lower risk. You'll often find low cap properties in highly desirable areas of growing markets, places like the in the major metropolitan areas on the west coast for example, such as Los Angeles, San Francisco bay area, Portland etc.
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.
As you've likely gathered, 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.
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. Furthermore, as discussed earlier, Class C properties 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.
What We Can Learn from Experts
At this point, you've likely realized that Class C investments are potentially lucrative, but also not exactly a cakewalk to source and manage. That is where identifying professional sponsors is important. Look for teams of industry professionals that focus on maximizing investor returns through hands-on management and a proven track record in renovating Class C and B buildings, and aggressively leasing up the properties to reduce losses from vacancies.
It is possible to invest in Class C properties on your own, but you are more than likely to pay the tolls that come with inexperience. A seasoned sponsor will have a network of real estate professionals who have decades of experience in value-add properties, and in excess of $1 billion in transactional experience. As an investor, you can make mistakes from which you can learn, or you can partner with experts and leverage their insight and experience to protect and grow your wealth.
GRM and Property Classes
Investors use the GRM, or Gross Rent Multiplier, as a metric to narrow down their list of potential investment acquisitions. It is defined as the ratio of the price of a real estate investment to its annual rental income before accounting for expenses like operations, management, property taxes, utilities, and insurance.
So how does GRM relate to A, B and C properties?
Typically, a lower GRM means that a property is potentially more lucrative than a property with a higher GRM. Class B and C properties located in secondary markets will usually have a GRM that is lower than a Class A property in a prime location. In a manner similar to cap rates, you can use the GRM as a quick indicator of how profitable a deal will be, and whether it is worth looking at the deal in any greater detail. That said, the GRM provides only a very rough indication of a property’s potential and must be used in conjunction with other metrics to property assess a deal.
What Does a Successful Class C Property Look Like?
After upgrades/renovations and operations/management changes, a Class C building should start to approach the levels of a Class B building in terms of amenities and tenant credit worthiness and should be in a location suitable for a Class B property. Over time your goal should be to improve your tenant base by attracting tenants with higher credit ratings and incomes through upgrades and repairs to units, additions of features like secured parking and security systems, and offering discounts to qualified renters, i.e. those with no history of eviction or housing related problems.
The only thing you are tied to is the location and while you may not be able to influence the direction of the neighborhood you sit in, you can use some of the above-mentioned strategies to mitigate problems associated with crime and quality of life issues. So, to answer the question – a successful Class C property sheds a poorly maintained exterior, substandard interior units, and poorly run operations, and embraces the qualities that define Class A and Class B properties.
So, Should I Invest in a Class C Property?
Class C property ownership is not for everyone, but when guided by a steady hand, it can be an effective wealth-building asset class. For those with substantial experience in the world of real estate, investing in a Class C property on your own is absolutely feasible. For those who may not have a track record in multifamily and commercial real estate, working with professional developers and sponsors may be a better path to generating returns with Class C property investments, while saving time lost to sweat equity and costly mistakes that come with any foray into value-add property development.
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