Most investors understand that multiple types of commercial real estate exist (e.g. multifamily, retail, industrial, etc.). But, each type of commercial real estate also includes multiple classes. These classes largely deal with a property’s quality. And, we’ll use this article to explain the different classes of multifamily real estate (A/B/C).
Specifically, we’ll cover the following topics:
- Classes of Multifamily Real Estate
- Why Multifamily Real Estate Classes Matter
- Final Thoughts
Classes of Multifamily Real Estate
Multifamily Real Estate Class Overview
Commercial real estate investors need to understand both property type and property class. While type defines function (e.g. multifamily), class refers to a property’s overall quality. Typically, the factors affecting quality include the location, available amenities, overall condition, and age of a property. Buildings that share these conditions tend to perform similarly in the market, leading investors to lump them into distinct property classes related to that performance.
In multifamily real estate, investors divide properties into Class A, Class B, or Class C, depending on the above quality factors. Class A includes the highest quality properties, Class B mid-level quality, and Class C the lowest level.
A multifamily property’s class often determines the strategy investors will take with that building. For example, many investors use a value-add strategy to renovate Class C properties to Class B (or Class B to Class A). Or, multifamily investors seeking stable returns may take a buy-and-hold approach with Class A properties only.
Regardless of strategy, new investors should have a solid grasp of Class A, B, and C multifamily properties.
Class A Properties
Investors typically view Class A properties as the safest multifamily investments. These properties are located in desirable neighborhoods in primary markets. Additionally, Class A properties tend to be newer, increasing aesthetic appeal while minimizing maintenance requirements. To attract higher-credit and -income tenants, Class A properties frequently have far more amenities than Class B or Class C (e.g. gyms, on-site pools, rec rooms, etc).
Due to the above traits, Class A properties command the highest multifamily rents.
Class B Properties
Class B multifamily properties fall into the quality tier just beneath Class A. These properties tend to fall on the outskirts of the desirable neighborhoods where Class A ones are located. Class B properties are generally older and in need of more maintenance. This age usually translates into fewer amenities and high-end finishes than Class A multifamily. Additionally, investors should closely analyze recurring and deferred maintenance issues before acquiring a Class B property, as these can seriously cut into your bottom line.
Class B properties rent at lower rates than Class A due to these factors.
Class C Properties
Class C properties pose the highest risk of all multifamily properties. They are located in the least desirable neighborhoods, are the oldest, and generally have significant maintenance needs – both recurring and deferred. Class C properties rarely have any common-area amenities. These traits lead to lower-income and -credit tenants who are more vulnerable to economic shocks, which increases the risk of default from an investor’s perspective.
Due to the above, Class C properties command the lowest rents of all multifamily classes.
Why Multifamily Real Estate Classes Matter
For investors, acquisition cost plays a key role in deciding what class of multifamily to purchase. As the highest quality, Class A properties cost the most, Class C the least, and Class B somewhere in the middle. When underwriting buy-and-hold and value-add deals, acquisition costs typically make-up the majority of your budget. Conversely, in a full renovation of a Class C property, the acquisition cost may prove less than the rehab budget. Regardless of strategy, it’s important to understand that you will pay a premium to acquire Class A properties, while Class C buildings generally cost far less.
However, as noted above, class also plays a major role in the rehab costs necessary in value-add and full renovation projects. As newer, high-quality buildings, Class A properties generally require little to no rehab cost. On the other end of the spectrum, many Class C properties require major improvements. Accordingly, investors may get a great deal to acquire a Class C property, but the rehab costs can potentially negate future returns on investment.
Risk, Stability, and Derived Valuation
As the highest quality properties, Class A buildings tend to have the most reliable tenants and require the least amount of maintenance. This decreases the risk while increasing the stability of those properties – simply less turnover and fewer tenant defaults than Class B and Class C properties.
In commercial real estate, valuations are derived from a property’s net operating income and capitalization, or cap, rate. Higher quality, more stable properties (like Class A) pose less risk, which leads to lower cap rates. All else being equal, the lower the cap rate, the higher the valuation (reflected in the higher acquisition costs for Class A properties). Conversely, Class C properties have greater maintenance requirements and tenant risk, making them generally less stable. This decreased stability leads to higher cap rates and lower valuations.
For investors focused on a quick exit from a deal, this relationship between multifamily class, stability, and valuation should play a central role in analyzing a potential deal.
However, not all investors focus on selling multifamily properties. Instead, many opt for a long-term strategy focused on recurring cash flow. A Class A property’s lower cap rates and increased valuations also translate to decreased cash flow (NOTE: conceptually, cap rate equals the return on investment for an unleveraged deal, that is, an all-cash deal).
On the other hand, the increased risk inherent to Class B and Class C translate to higher cap rates, which can – potentially – lead to increased cash flow. If investors properly analyze a Class B or Class C building’s maintenance needs and mitigate these needs through renovations and regular maintenance, these properties can generate significant cash flow.
While several classes of multifamily real estate exist, there isn’t one “best” class from an investment point of view. Instead, investors should weigh all the pros and cons of individual deals, to include the property class and associated considerations.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available multifamily real estate investment opportunities – in any property class.