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Understanding Class A vs. B vs. C Multi Family Real Estate
By Adam Gower Ph.D.
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 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.
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.
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, 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.
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. Again, 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.
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.
Can An Asset 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.
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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