When discussing commercial properties, you will very often encounter a letter scale of Property Classes, commonly A through D, used to describe the character of the property – both building and neighborhood. They are intended as a shorthand way of describing the type and general quality of the investment being considered.
What are the Property Classes?
Class A properties are the more luxurious and expensive ones and Class D the least. The value of this shorthand is to give investors a quick way to discriminate between different levels of risk and reward when investing in multifamily deals. Class A typically offers lower returns, but a safer investment. Investing in Class D properties offers substantially higher returns, but significant risk as well.
That fancy new development that is just about to open up near all the hard-to-get-reservations-for restaurants? Probably Class A. That beat up building that you think no one should have to live in? Probably Class D. The one that looks like it could be livable if someone just took proper care of it? Maybe Class C.
But those are pretty subjective measures; more how we “feel” about a place, less how we might analyze it. Is it possible to put some more objective criteria to this rating system? It turns out there is.
Common aspects to consider when classifying a property are:
- It’s location
- Age of the development
- Number and type of amenities (swimming pool, community room, playground, etc.) provided
- General condition of the property
- Occupancy and turnover rates
Here is a table that breaks down these factors for each of the four property classes:
As with other classification systems, you will find variation in how these classes are described and bracketed. This general guide will give you a feel for it, but make certain you know how the terms are being used by the deal sponsor with whom you are investing.
For this article, assume we are only considering multifamily properties (apartment buildings). While this classification system can be applied to other property types, focusing on just apartment buildings will help us keep it simple.
A Bit More Detail …
Class A Properties are newer, well-maintained, often amenity-rich. Tenants might enjoy a swimming pool, tennis or basketball courts, community room or an on-site dog run. They often have high occupancy rates, but are sometimes vulnerable to oversupply – high levels of competition from other nearby Class A properties. Class A properties, as a rule, offer lower returns than other classes of multifamily properties because in most markets they are considered safe investments delivering predictable returns.
Class A properties typically collect the highest rents in a given market, and therefore are the most expensive (cost per door) properties to buy. They also offer the lowest risk along with comparatively lower, more consistent returns.
Class B Properties are just a rung below Class A properties, perhaps being a bit older, or (even if newer) offering fewer amenities. Nevertheless, Class B properties are generally well-maintained and provide practical amenities like on-site (or even in-unit) laundry facilities, and access to high-speed internet service for tenants. Depending on location, there might be a swimming pool or hot tub.
This class of buildings are considered a “sweet spot ” for investing. The cost per door is more reasonable than Class A while still offering fairly low risk. While maybe not as reliable as Class A properties, they can be solid investments with sound investor returns.
Class C Properties are a bit older, may tend to have fewer amenities, and are generally considered “work force” housing, catering to people with blue collar jobs. Sometimes needed maintenance is deferred, making the building less desirable to prospective tenants.
Sponsors often seek out these types of buildings with the intent of raising them up into C+ (yes, you can add +’s and -‘s to the class levels to give nuance to your descriptions) or B class properties. But this strategy also relies on higher up-front costs in rehabbing a property and requires a strong management team to improve the property, keep occupancy high, and bring in new tenants to occupy the improved apartment units.
When you read about “forced appreciation”, this is what is being described – investing in a building in an effort to bump it up to a class above where you bought it. When deal sponsors properly handle these responsibilities, they can manage the risk and create handsome returns for their investors.
Class D Properties tend to be older buildings in poorer neighborhoods with higher maintenance needs. A history of failing to properly maintain these properties can aggravate other problems, like long-term deterioration of the physical buildings themselves, and this can in turn lead to high tenant turnover as existing tenants seek better housing elsewhere.
Some investors have built a robust investing model around Class D properties. But, because rehab and maintenance can be ongoing and costly problems, passive investors in these investments should at least make themselves aware of the financial risks before investing.
Again, these are not rigid categories. A 10-year-old building that has been poorly maintained might be judged as Class B, and a 25-year-old building that has been impeccably maintained (or has just been fully rehabbed) might hold on to its Class A categorization for years to come. A brand-new building in a middle-class neighborhood built with fewer amenities may start its life as Class B housing. Choosing a classification requires finding a balance after considering all of the relevant information about a property.
In Conclusion
When an opportunity comes across your desk (in your email), one of the very first things you will see identified is the class of property involved. It is important to know what type of investment you like and the amount of risk you feel comfortable incurring. This gives you a handy way to weed through the ones you don’t want and further explore the ones that fit your criteria.
