Class A, B and C Real Estate: Keys to Success When Investing in Any Property Class
The commercial real estate industry uses a lot of lingo. This can seem daunting for first-time investors looking to make sense of different property types. One of the ways to distinguish amongst property types, for instance, is by a property’s class rating.
Generally speaking, properties are classified as either Class A, Class B, or Class C. This is true across all commercial real estate asset classes, regardless of whether you’re referring to office buildings, retail centers, multifamily apartment buildings, or industrial and warehouse facilities.
In this article, we look at the distinguishing characteristics of Class A vs. Class B vs. Class C real estate. Any prospective investor should understand the differences between product types prior to investing in a deal. We’ll then look at specific keys to success for investing in any one of these property classes.
Features of Class A Properties
Although there is no universally accepted definition of a Class A (or Class B or Class C) properties, most in the industry consider Class A buildings to be newer with higher-quality finishes, amenities, and accessibility. Class A properties tend to be located in the urban core, and often have a bespoke brand or lifestyle associated with them.
Class A properties tend to be extremely desirable, investment-grade properties with the highest quality construction and workmanship, materials, and systems. They often contain unique architectural features, robust services, and popular amenities, and utilize first-rate maintenance and management.
Class A properties are also distinguished for the tenants they attract. Most Class A properties will be occupied by prestigious, highly credit-worthy tenants that are willing to pay top-of-market rental rates. Class A properties are frequently bought and sold by national and international investors, including institutional investors such as life insurance companies and pension funds that are willing to pay a premium for quality assets.
The desirability of Class A buildings means that they provide more liquidity than Class B or Class C properties. In other words, there is enough consistent interest in Class A properties that an investor can expect to have an easier time selling the property than in trying to sell a Class B or Class C property in the same market.
For all these reasons, Class A properties are considered one of the safest additions to an investor’s portfolio. Conversely, they offer some of the lowest returns as the trade-off for this lower risk profile.
Features of Class B Properties
A Class B real estate tends to offer more utilitarian space with fewer amenities than a Class A building. It will typically have ordinary architecture design and structural features, with average interior finishes, systems, and floor plans. The systems will be in adequate condition, and the property will be structurally sound but not overwhelmingly impressive.
The maintenance, management, and tenants in a Class B property are considered good but not necessarily great. Class B properties may also be less appealing to tenants, as the buildings may be unimpressive in traits such as floor plan configuration and building or facility condition. As a result, Class B tenants may be less established, have lower credit, or may be unable to sign longer-term leases. Therefore, while Class B buildings tend to attract broad interest among a wide range of users, the rents these tenants are willing to pay tends to be less than what Class A properties can command.
Class B properties are often considered more of a speculative investment than their Class A counterparts. Class B properties will occasionally attract attention among national investors, but most investors tend to be local to the marketplace.
While Class B properties tend to be considered a “riskier” investment than Class A properties, there are still several benefits to adding a Class B building to your portfolio. Namely, well-located Class B properties can generally be purchased at a lower price and can stabilized over time. As building improvements are made and leases turn over, the new owner can increase rents and improve the tenant mix. With thoughtful stabilization and/or value-add strategies, an investor can actually realize greater returns through Class B properties than they might be able to achieve by investing in Class A buildings in the same market.
Features of Class C Properties
Class C buildings can be highly 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. Still, a well run Class C multifamily property can offer workforce housing/affordable housing solutions, and be valuable both for investors and for the communities where they are located.
Primary Indicators of Property Class
There are several factors that affect a property’s classification, including location, the age of a building, property condition, amenities, and occupancy. Note that these factors are generalizations, and there are 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, 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 that some Class A properties are located in highly desirable urban locations where the school districts might be considered 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 may have an excellent location but a building that leaves much to be desired because of age, condition, or lack of amenities.
Age of Building
The age of a multifamily 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.
An exception to this rule happens when an older building such as a historic property is gut renovated to include high-end finishes and other amenities akin to their newly constructed peers. This kind of project often fits into Class A.
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 multifamily 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 multifamily realm, 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 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 qualified tenants: high-income earning professionals. Class A buildings appeal to the masses, and therefore usually have very low vacancy and top-of-market rents. Class B and C properties usually have less desirable tenants (typically, people who earn less) 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, or who want to be located close to a plant or hospital in an outlying area where Class A housing is harder to find.
Keys to Success When Investing in Any Property Class
Many investors struggle to determine which property class is best for them. There is no right or wrong answer—each property class has its own pros and cons. Each of the risks associated with a specific property class can be mitigated with thoughtful planning and discipline.
Class A Keys to Success
Class A properties are the most sought after, which means they command the highest price. Any investor looking to purchase Class A property will want to ensure they are not overpaying for the property. Pay close attention to net operating income. Analyze variable factors such as how far can rents be pushed and on what timeline. If a property already commands the highest rents in the marketplace, there may not be room to grow for some time, which needs to be factored into the underwriting.
Another key to success when investing in Class A real estate is to factor in any costs associated with keeping the property in first-class condition. This means refreshing amenities and common areas on a timeline basis (every 3-5 years) and integrating new building technology (e.g. smart thermostats) and other amenities as consumers drive demand. The most successful Class A property owner never skimp on property improvements and always stay at the cutting-edge of tenant wants and needs.
Class B Keys to Success
Before investing in Class B property, consider what is driving the property’s classification. Is it location? Age? These are variables you can never change. Compare these to features such as property condition, amenities, and occupancy – these can all be improved upon with the right expertise, resources, and time. Successful Class B investors will look for properties that have a strong foundation, such as being located in a great area, but that otherwise need improvements to maximize the return on investment. These become value-add opportunities where bridge financing like Lima One Capital’s multifamily loans are a perfect fit.
Class C Keys to Success
Class C investments are considered the riskiest, but they can offer the greatest returns. One key to success when investing in Class C real estate is to thoroughly screen tenants and keep strong cash reserves on hand. Tenants in Class C properties tend to be less stable, turn over with more frequency, and worse, more likely to require eviction. Investors will want to be sure they aren’t over-levered when buying the property, and then keep plenty of cushion in the bank in the event of cash flow disruptions.
Location is also important to Class C investments. Many of these properties are located in fringe neighborhoods, but these same neighborhoods might be improving. Look for Class C properties that appear to be on the upswing. Indicators such as population growth and new household formation are positive signs. Look for opportunity zones or other areas where communities are trying to increase workforce housing options—getting community support may make the process of permitting value-add construction and/or improving tenant population easier.
A final key to success for Class C properties is to consider the various value-add strategies that may be deployed to improve the building, its amenities, rents and occupancy. Sometimes, small improvements can go a long way in a Class C property. Other times, more wholesale upgrades are needed to bring in line with market competition. It’s always important to evaluate the cost (time and money) needed to deploy specific value-add strategies. Determine what’s realistic and what’s pie-in-the-sky before investing, and make sure your numbers operate with realistic rent rolls numbers.
Remember that there’s no right or wrong commercial real estate investment strategy. It can be equally as lucrative to invest in a Class A property as it is a Class B property—there are just different processes to follow and different paths to success. Choose your path based on your individual risk tolerance, investment horizon, portfolio diversity, and access to capital. And of course, remember that Lima One Capital funds Class A, B, and C multifamily properties not just in major cities but in the top 250 MSAs. If you have a project in view, contact us today to find out how you can close quickly and close with certainty with Lima One Capital.