Property classes allow commercial investors to truly understand the value and potential future value of a real estate asset.
They’re meant to give interested parties a general idea about the quality of a property based on various criteria such as the building’s age and condition, location, and much, much more.
In this post, we will define the most common property classes—A, B, and C—and look at how you can identify your next investment based on its class-level.
About Property Classes
Class assignments are based on a combination of physical, geographic, and demographic factors. They describe the characteristics of buildings, and therefore can be used to evaluate potential commercial real estate investments.
While classes A, B, and C are typically always used, some CRE investors and brokers have very granular breakdowns, classifying buildings from Class A through Class F, and may even include subcategories like B+ or B-.
From an investment standpoint, each building class represents different levels of risk and return. Investors can use the differences in property classes to determine how each property fits within their strategy – the return objectives and amount of risk they are willing to accept to achieve those returns.
So then, what is the difference between the classes? The short answer is that it is all relative.
A Class A building in one market may not be considered Class A somewhere else. Each class holds a certain value relative to the market where the property is located.
Class A Property
Class A properties are considered fairly low-risk assets by real estate investors.
These types of buildings are often newly built and have high-end finishes. They are located in high-income, low-crime-rate areas, usually outside of cities.
They tend to be constructed in neighborhoods with good schools, access to highways, and shopping and medical facilities. Such areas also boast measurable growth in population, jobs, and infrastructure that creates high demand for prime real estate.
Additionally, Class A buildings are likely to be in locations with a high percentage of owner-occupied properties. Owner occupants tend to care better for their homes and neighborhoods, as they have invested directly in the area.
Due to all these factors, Class A rental properties usually demand higher rental rates and have low vacancy. Also, because they are newer, they tend to have lower maintenance costs.
The high demand for these low investment risk properties has lead to higher purchase costs. Because of this, Class A buildings generally offer lower cash flow than Class B or C assets. On the positive side, the high demand means that Class A real estate is also easier to sell.
Overall, Class A properties offer good, safe opportunities to investors who want fewer issues and fewer expenses.
Class B Property
While these properties tend to be a bit older than Class A, they can still have quality management and tenants. Generally, Class B buildings are located in well-kept areas with slightly lower income rates than Class A, and more investor-owned and tenanted properties.
It is worth mentioning that some Class B buildings’ location and circumstance may allow the possibility of restoration to Class A status through facade renovation, common area improvements, and amenities upgrades.
Class B properties offer investors the opportunity to create a substantial cash flow.
Class C Property
Class C properties can be very lucrative investments with the right strategy, however, they carry the highest risk of any building class.
Typically, these properties are more than 20 years old and many show visible deterioration.
Class C buildings are often located in less than desirable areas that may have higher crime rates. They tend to be predominantly investor-owned and occupied by tenants in lower socioeconomic groups.
While Class C properties offer the potential for higher cash flow than other building classes, they often require a lot of improvements and hands-on management. For that reason, Class C investments are usually taken on by experienced investors and property managers.
How to Decide Which Class to Invest In
In general, there are no rigid guidelines when it comes to investing in real estate.
For example, you may find a Class C property in a Class B area that could be the right opportunity for value-add investors looking to turn profit. Again, it is all relative.
The most important takeaway for investors is to understand that each property class represents a different level of risk and reward.
When to Choose Class A and B+ Properties
Class A properties tend to have the greatest potential for appreciation. Additionally, because risk increases with lower property classes, Class A buildings are viewed as the least risky investment option.
Class A provides investors with a peace of mind because they are putting their money in top-tier properties with little or no outstanding issues requiring further capital expenditures.
It is worth mentioning, however, that despite better property conditions, Class A real estate can become sensitive in economic recession times when high-income earners may suffer from increased unemployment.
If you are looking for investments with the highest appreciation potential and you aren’t worried as much about the initial cash flow, you would want to look for A and B Class properties in affluent areas, and avoid Class C buildings altogether.
When to Choose Class B- and C Properties
If you are looking for investments with strong cash flow, but appreciation is less important, you should consider Class B and C properties in less desirable areas.
As we mentioned earlier, Class C properties are the riskiest real estate investments. Risk can be in the form of dealing with evictions and delinquent rent payments. Vacancies also tend to go up as you move towards Class C properties.
Following the risk curve is also the level of management required to operate the property. Lower class buildings usually attract lower quality tenants so property management will be more intensive. Class A assets tend to run smoothly, whereas Class C properties will require greater oversight to collect rents, perform maintenance, and deal with tenant problems.
It is important to note that Class B and C properties are often bought and sold at higher cap rates than Class A. Investors are paid for the additional risk of an older property with lower income tenants.
To conclude, the class of a property can have a great deal of influence on the stability and growth appreciation of the investment over time. Investors looking for capital preservation should consider Class A whereas those interested in cash flow may do better with Class B and C properties.