When you are looking at properties and the area they are located in, you will hear about different classifications: Class B area or a Class C building. Getting to know these important factors will help in outlining the quality and rating of a property.
Today, we go into what the classes for buildings and areas are and why it matters.
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Property and area classifications will reflect the risk and return of the deal because they are graded according to a combination of physical and geographical characteristics, respectively. The letter grades are subjective. They are given to properties by brokers, buyers and sellers that consider the combination of factors like the age of the property, location, tenant income, amenities and rental rate. This variety of items will drive the cap rate, that as you may already know will shift also with the supply and demand cycle of the market. But if you are in tune with your area, you can determine whether the asking price is in line with the market.
There is no formula by which properties are placed into classes, but the common breakdown is A, B, C and D. From here, there are two different classification when we talk about a property: 1) The Area Class and 2) The Property Class.
The Property Class is centered around the physical condition, the age of the building, amenities, and the demographics of the community. With the Area Class, on the other hand, you look at the age of the neighborhood and what is local to the neighborhood. You consider crime rates, the demographics, typically broken down by zip code. You are also looking at what kind of commerce or retail is in that area. For instance, if there are a handful of national stores near your property versus an industrial trucking side across the street from the property, those are two different areas with two different classes.
Before we get into the classes of the area and property, let’s go over why we use them in multifamily and commercial investments in the first place.
When a broker or a seller tells us the classification of a property, it is supposed to let us know what kind of demographics and neighborhood we are talking about and the condition of the property take a look at it. Classes also tells us what the cap rate of the property and the area are. Classes are like grades – from Class A to Class D. The higher the grade, the better the property condition. The better the property is, the lower the cap rate. When it comes to Class A, think of properties that you will find at a busy downtown area. It could be an all glass multifamily tower with pool, sauna, shopping on the first floor and a very affluent tenant profile. A building like this may cost $50M. The cap rate will be low on an asset like this, but a large hedge fund with money to put to work wants that degree of certainty and doesn’t mind paying a premium for these great properties.
Keep in mind that classes of property not only vary from A to D, but there are degrees within each one. You will have A- or B+ properties. Perhaps you will have a C- property but in a B area. Generally, the rating will go all the way from D- to A+ and everything in between. And because brokers, sellers and other people classify the property or area differently, it can be a bit subjective. This is especially important to remember when you get a new offering memorandum from a broker with a bright-colored Photoshopped building on the front, meant to show a higher property classification.
It’s worth noting that the classification of the area is far more important than the classification of the property. If you have a C- building in a B+ area, you can make renovations and drive higher rents to get that property to a B+ like the area it’s in. In contrast, if you have a B+ property in a C- area, it will be hard to get the affluent people to move there as they will not want to be in an area where they do not have the amenities they want or where they don’t feel safe spending time outside the property.
As I mentioned, getting into the area classes is much more important than the property classes.
In a Class A area, you are in the best neighborhood in the city. It will have the best schools, lots of high-end retail, maybe a top shopping mall nearby and plenty of restaurants. The neighborhood is typically no more than 5 years old.
In a Class B area, it was perhaps the Class A of before. It still has great neighborhoods and a low crime rate. The school system is decent and the homes are still pricey. The neighborhood may be 5 to 10 years old and the styling of the houses may be starting to look a little dated.
In a Class C area, you will have your workforce housing. Neighborhoods are decent. The homes are more than 10 years old but are usually 30 to 50 years old – sometimes even older. The community can be made up of blue collar workers, people in food service or just an everyday worker. The school system is not the best but not the worst. The people that live in Class C & B areas have a high dependency on jobs. They live from paycheck to paycheck.
In a Class D area, you would not feel safe walking on the streets at night. In the real estate business, they refer to this area as the “war zone”. Here, you will see graffiti, gangs and homeless people hanging out in front of the property. The school systems are very poor, there will be high crime and there are boarded up homes and buildings in the area. These are your highest cap rates, but also your highest risk properties.
When we are looking at the properties, they will follow the same grading level, with A being the highest quality and D with the poorest quality.
In a Class A property, you are looking at a new construction property. It may have a doorman, a resort style pool, clubhouse and fully equipped gyms with a sauna. These units will have quartz countertops, backsplashes, stainless appliances and upgraded flooring. They put a great deal of effort to appeal to the affluent crowd that will pay the highest rents in the area. They are the best looking properties with the best construction and have high quality building infrastructure with up-to-date technology. As you can guess, the Class A properties are usually in the Class A areas, so the residents have access to great shopping, restaurants and leisure activities. Sometimes, you will see a Class A property in a transitioning area that may be going through gentrification. The landlords of these types of properties are usually institutional investors and they are not concerned with a low cap rate. Rather, they are looking for safe and consistent returns on their investment. But we need to bear in mind that Class A tenants may be sensitive in times of an economic slowdown if these high income earners suffer from a job loss or business slowdown.
In a Class B property, the buildings would have been well maintained and still have decent amenities. They will be on the older side, 8 to 15 years old, but still look great. You will see the granite countertops of yesteryear, white appliances and nice gym. Similar to what I said about the area, these properties may have been Class A before, but look dated. The people that would live here would be mid-level managers, business professionals or people with young families and higher than average income. Often times, value-add investors look for these properties as investments since well-located Class B property can be returned to a Class A through renovations, unit improvements, updates to amenities or technology upgrades.
In a Class C property, they are still in good condition and are in decent locations. They don’t have any fancy amenities, if any at all. There may be laundry or a small gym, but that is about it. Regardless, there is still a sense of community. Like I mentioned, this is where the local workforce housing will reside. You will have blue collar workers and young people just starting out. These properties, like the area, can be quite old – built 20 to 50 years ago, but mostly on the older side. Hopefully, they have been maintained – (or not so you can pick up a deal) – but it costs more money to operate because it is older. Because the category is so big, the range of property is quite large. So a Class C property can mean two different things to two different people. Like I said earlier, the people that live in Class C properties are dependent on jobs. They live from paycheck to paycheck. Underwriting your tenant – like I cover in my other content – becomes more important in this asset class too. This is what most investors are looking for to get the biggest bang for their investment dollars.
In a Class D property, these are buildings in the poorest condition. The area may have been great at one time, but now it houses tenants that do not have a steady source of income or rely on government assistance just to make ends meet. Because it’s in a high-crime area, you would need to secure with steel doors, cameras and fencing to keep the bad people out. I recommend my coaching students to avoid these areas when starting out.
In a strong economy, affluent people will move from their Class B unit to a Class A property. A Class C resident will upgrade to a Class B unit. And a person living in a Class D will move to a Class C property. In a weak economy, the reverse tends to happen and each tenant profile will downgrade as they either tighten their belts or are worried about their income stream.
My partners and I prefer to invest in Class B and C buildings in Class B areas. This workforce housing is always in demand and will weather the storm of economic cycles that happen every 8 to 10 years.
Finally, keep in mind that this is just a general guideline of multifamily classification. There is no formal standard for classifying a building or an area. Buildings you are looking at should be viewed in the other properties in the local submarket. Meaning, a Class B property in Miami is not the same as a Class B property in Cleveland or as in Dallas. And a Class C property in New York City will be probably more desirable than a Class C property in Topeka, Kansas.
Anyway, what sort of assets do you invest or would like to invest in? Let me know in the comments. Also, let me know if there’s a topic you’d like me to cover!
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