Are “Class A” Properties A Better Investment Than Class B Or C?
There is a lot to think about when it comes to property investment.
Every decision seems incredibly important when you are working with such large sums of money. On top of the budget, loan approval, legal requirements, and partnerships, you need to find the right property.
Like any investment, there will always be a level of risk involved.
Depending on your situation, you may choose to play it safe with a low-risk endeavor. Or you may be at the other end of the spectrum and ready to play with fire.
The thing that matters most is being able to assess the level of risk involved in an individual deal.
Many people use a property’s class to help them establish the risk involved. But, what do the classes actually mean? Is a Class A property less risky than a Class B or C in this current market?
Those are the questions we are going to dive into today.
So, let’s explore what the different property classes mean and whether you should be considering a Class A property investment or whether a Class B or Class C is better for your particular circumstances.
What Kind Of Tenants Do You Want?
When purchasing a home for yourself, your wish list will be easy to form. After all, you know what you want from a property and can picture yourself living there.
But, when you are investing, the Wishlist can become a little more complicated. You have to guess what someone else might consider important in a property.
While there will be numbers and legalities involved with every deal, there is also the human element. When investing in a Multifamily property, tenants will always be part of the equation. So don’t forget to consider the kind of tenant you want to attract. By that, we mean, are you wanting to house the general workforce, professional couples, or more mature couples?
Each will have their own “Wishlist,” By understanding your tenant, you can also understand what class of property they would personally choose.
The Different Property Classes
When it comes to investments, there are a lot of options. The first distinction is choosing between a commercial or residential investment.
Then, you can dig even deeper into the type of property – will you choose a multifamily apartment building, a single dwelling, a condo, or something else entirely.
Taking it one step further than the type of property is considering the class. So, what does it mean if a property is marketed as a Class A, Class B, or Class C property? And how do you know the difference?
Put simply, each property classification will reflect a different level of risk and return. This is why it is an essential consideration in any investment decision.
How Are The Properties Classified?
Every investment property will be graded or “classified” according to a combination of different factors. The classification will depend on the geographical and physical characteristics of a property.
These characteristics include things like:
- Age of a property
- Location of a property
- Condition of a property
- Tenant income levels
- Growth prospects
- Rental income
There is not a precise formula that places property into a certain class. Rather it looks at the general level of risk and the return you might expect to receive. To keep the classification system simple, letters are used to break down the different levels of classification.
Class A Properties
Class A properties represent the highest quality buildings in a particular market or area. They are the luxury apartment option.
Generally, they are newer builds, having been crafted within the last 15 years. They contain top amenities like gyms, resort-style pools, rooftop patios, and even dog parks. Typically, they have high-income tenants and have low vacancy rates.
These are the properties that are well located in desirable neighborhoods (with desirable school zones to match) and are typically managed by a professional property manager. Because of that, they are well maintained and require less input from an investor on the maintenance front.
As they are more desirable than other property classes, these are the properties that can command the highest rent. They are considered as the cream of the housing crop.
Class B Properties
It makes sense that Class B properties are a step down from Class A properties in quality.
They tend to be older (built in the last 20 to 30 years) with little to no deferred maintenance issues and may also have lower-income tenants. Sometimes they are professionally managed by a Property Manager, but not always.
Don’t be put off though, Class B properties are still pretty nice. They have great finishes, are typically well maintained, are situated in nice neighborhoods, and come with the added benefit of being a “value-add” investment opportunity. That means, with a bit of work (like renovations and upgrades), they can potentially be elevated to Class A level.
Some may have great amenities, but others will not. For all of these reasons, rents are lower at a Class B property than a Class A. They appeal to a working-class tenant, which can be considered a huge recession-proof benefit.
Class C Properties
Class C properties are a bit like getting a C on your school report card. Not bad, but not great either. But, that isn’t to say that you should write them off completely, you should just understand the level of risk before jumping in with both feet.
Class C properties are usually older, located in developing neighborhoods, and almost always need some renovation to bring them up to date. Often the paint will be peeling, the roof might be old, and the apartments may need refreshing.
The building won’t be falling apart, but it won’t scream luxury either! Because of this, Class C properties often have much lower rent than their Class A or Class B counterparts.
Class D Properties
Yes, there are properties in the D class too. Like a D on your report card, you definitely want to avoid getting one! There is usually plenty of deferred maintenance to remedy which is apparent when you look at the building.
Usually situated in the rougher areas of town, they are not somewhere you want to think of your own family living. Dated and worn, the building will need a LOT of work, and the rents will be the lowest in the market.
Is Class A The Best?
You may automatically assume that Class A is your best investment as they are the nicest properties in the nicest neighborhoods with the highest paying tenants. But, all of that comes with a big price tag. They may not always show the biggest return.
At the opposite end of the spectrum, you wouldn’t want to sink money into a sketchy Class D property. These kinds of properties are likely to show little return on your investment.
But what about the property classes in the middle? The Class B and Class C properties. Could they be the best place to invest your money?
Let’s explore that idea in greater detail.
Protecting Your Investment
If the events of 2020 taught us anything, it’s that you cannot predict what might happen in the world. No one could have imagined the impact that a single virus could have. Not just on the health and wellbeing of millions, but also on the economy.
While the 2010 recession was dubbed a “once in a lifetime” event, the fallout of 2020 confirms that we cannot be sure of that. Another recession could loom much sooner than anticipated. So, it is important to consider how recession-resistant your investment would be.
Regardless of what is happening with the economy, people will always need a place to live. But, will they choose a luxury living option if money is tight or they have just lost their job?
Mitigating Risk In A Recession
When the economy is impacted and unemployment rises, people start to tighten their budgets. They may not be able to afford the high levels of rent that a Class A property requires. They may even decide to downgrade and move to a Class B or Class C property instead.
Investing in recession-proof assets can mitigate the risk factors for your portfolio.
So, what do we mean by recession-proof? Well, those are the properties where the likelihood that the principle will drastically or disproportionally reduce in a recession situation.
Let’s put the property classes aside for a minute and look at it in terms of numbers. Say you have a tenant base that is earning between $50,000 and $60,000 annually. If a recession hits and their income drops to between $40,000 and $50,000, then you will still have plenty of tenants.
However, if your tenant base was used to earning $100,000 annually and suddenly find themselves earning $60,000 then you may have challenges in getting them to pay the rental rates of a luxury apartment.
Is Class A More Volatile Than Other Property Classes?
With our numbers exercise, we have just highlighted that people may not be able to afford Class A rent levels in a recession. And most newly created apartment buildings are being built to a Class A standard.
So, are they the right place to put your money?
On the face of it, Class B and Class C properties may look more attractive than Class A property due to the recession risk mitigation.
However, it is worth considering other factors such as CAP Rate, scalability, higher multiple of income, and the tenant base itself. They may help to make a Class A property just as attractive as a B or C.
Let’s dive into this a little deeper.
CAP Rates (Capitalization Rates)
A Capitalization Rate, most commonly known as a CAP Rate, helps to determine the rate of return that an investment property will generate based on its current market value. The CAP Rate of a property is calculated by dividing the annual net operating income by the total acquisition costs.
If we look at the last major recession of 2010, there was a significant spread between the CAP Rates of Class A and C properties. Meaning that if Class A was trading at a 5% CAP Rate, then Class C could be trading at 7% or 8% CAP Rate.
As the property cycle continued, the spread between Class A and Class C began to deteriorate as people searched for more yield. What happened was that a Class A asset would potentially go from trading at a 5% CAP Rate to below 4%. The deals didn’t make sense to investors anymore, so they looked to move to a Class B property. Those who had Class B looked to move to a Class C investment bid to chase yield.
What ended up happening was that the spread got lower and lower. What was once a 300 basis point difference between Class A and Class C could now be as low as 50 basis points.
What does all this mean for risk mitigation?
Is Class A Suddenly More Attractive?
With the spread between property classes being so low, it makes the argument against Class A properties less compelling. Here’s why.
Compared to the other property classes, Class A properties are larger assets with a more desirable tenant base. That means they are more scalable and at less risk of a significant snapback in CAP Rates.
Also, the lower the CAP Rate of a Class A property, the higher the multiple you will earn on your income. On a standard property, if you are able to reduce your operating costs or raise your rents to add an extra $100,000 in Net Operating Income (NOI) to a property with an 8% CAP Rate, you are adding around $1.25 million in valuation.
However, if you apply the same strategy to a Class A property that is trading at 4% CAP Rate, and adds the same $100,000 of NOI, you would end up adding about $2.5 million of valuation because of the multiple of that income is higher in Class A. With the same NOI increase, you have doubled your valuation increase.
Which Class Is Best?
If you look at all of the factors, we cannot conclusively say that one property class is any better than the other. There isn’t one class that is guaranteed to provide you with the best return on your investment. It is about assessing each deal individually.
What we can say is that considering diversity in your investments can be a good thing. Having diversity in your portfolio, such as investing in different property classes, can help you to mitigate risk.
If you aren’t sure about which path is right for you, then the best thing is to seek advice from an experienced professional. They can help you run the numbers, assess the different volatility valuations, and explore the scalability of each deal.