With the advent of new technology and changes to federal regulations. It is now easier than ever for individuals to invest in “institutional-quality” real estate. Those who do so often overlook the benefits of investing in Class C properties. An asset class that often gets overshadowed by its Class A and Class B counterparts.
In this article, we look at the many advantages of buying Class C apartment buildings. As you’ll see, these properties provide tremendous upside potential when managed by an adept development team.
Characteristics of Class C Properties
Before diving in, it’s worth acknowledging some of the differences between property “classes”.
Class A properties, are the most “premier” of the bunch. Often times identified as the highest quality. These properties tend to be newly constructed buildings in the most desirable locations. They feature robust amenities and are often times professionally managed.
Given these characteristics, these buildings are very expensive. They are also often difficult to acquire, and tend to draw the most interest from well-heeled institutional investors.
Those Class C properties, on the other hand, tend to be located in older, more mature areas. Usually constructed at least 30 years ago. In many cases, also may not have gone through any significant upgrades since then either.
Deferred maintenance is common, and often require costly improvements to be made. Such as a new roof, replacement siding, or new kitchens/bathrooms in each of the units.
Class C apartments are leased by
lower- to middle-income individuals.
In the short-term, absent any value-add improvements, these properties often will not experience any meaningful appreciation.
Typically, Class C apartments are leased by lower- to middle-income individuals. They may be long-term tenants who have rolled into month-to-month leases. The building management may not have a handle on area rents, so they may lease units below market value. At a minimum, these units are leased for much less than Class A properties.
Class B buildings, as one would imagine, fall somewhere between Class A and Class C properties. They also often exhibit some combination of the characteristics of each.
Why Invest in Class C Apartment Buildings
Given the characteristics of Class C buildings, some may wonder why anyone would buy this type of investment real estate. Yes, they are more expensive to improve and maintain. However, owning Class C properties has many other benefits.
Low acquisition costs.
Many investors specifically seek out Class C buildings. These are their “go-to” properties. Often because they do not cost as much as Class A or Class B properties in the same market.
This means the barriers to entry are lower. Someone with less capital can more readily invest in a Class C building than they could another, higher-grade asset.
Relatively easy to lease.
In many markets, Class C properties are the most in-demand type of housing. These buildings essentially provide what could be considered the nation’s “workforce” housing. They are among the most affordable and appeal to the masses.
In turn, Class C apartments tend to be relatively easy to lease.
Someone with less capital can more readily invest in a “Class C” building than they could in another, higher-grade asset.
This is good for owners who plan to hold Class C properties for some time, even if they ultimately plan to invest in value-add improvements that bring the property to Class A or B condition. Unless the region’s economy is falling apart and people are leaving the area in droves, most Class C properties will have a relatively low vacancy, with units re-leasing rather quickly after a tenant moves.
“Sticky” tenant base.
Most people who rent Class C buildings tend to have relatively modest expectations. Tenants understand that the property will not have the latest bells and whistles and that is perfectly acceptable for majority of them. They just want a clean, safe place to live where the building management is responsive and treats people well.
If an owner can deliver on those things, they are not as likely to move down the street to a competing property. These tenants are said to be “sticky”. For example, they are not as likely to move from one year to the next, at least as often as one would expect with a Class A or Class B apartment building.
Little fear over new construction.
As the costs associated with new construction have risen, it has become nearly impossible to build new Class C apartment buildings. The numbers simply don’t pencil out. Therefore, Class C apartment owners do not need to worry about competition from new construction.
In fact, the opposite is true. New construction often bolsters demand for Class C buildings.
Class A properties that come to market often replace Class C properties, thereby reducing the number of Class C units available to rent. Many of the would be renters cannot afford the rents at new Class A buildings and in turn, must compete for lower cost Class C units as inventory dwindles.
Myriad ways to add value.
Given the high cost of new construction, a great alternative is to invest in Class C properties and upgrade them using various value-add strategies.
There are many ways to add value to Class C buildings to make them much more valuable. In terms of physical improvements, a “light” value-add strategy might include cosmetic improvements such as new paint and carpet. At the other end of the spectrum, “heavy” value-add improvements might include wholesale building upgrades—from system replacements to gut-renovation of individual apartments.
Sometimes, a heavy value-add strategy will include integrating new building amenities (e.g. cashless washers and dryers, EV charging stations), adding the latest property technology (e.g., smart home devices and speakers), and then repositioning the property under an entirely new brand—one that promotes a certain type of lifestyle and attracts a specific renter demographic.
When using a heavy value-add strategy, the building often moves from the Class C to Class B category. This re-classification makes the property more valuable for investors who benefit from both higher rents and property appreciation.
Sometimes, even though a property is in relatively good shape, high vacancy or other operational deficiencies classify it as Class C. In situations like these, a new owner can add value by making operational improvements. This can include hiring a new property management team, improved marketing, and lowering the operational costs through things like a ratio utility billing system (RUBS system) that shifts the utility cost burden to tenants instead of ownership.
The value-add strategy deployed will depend on the owner’s expected business plan. Different ownership groups will utilize different strategies for raising the value of Class C apartment buildings.
High(er) risk, high(er) reward.
Some people prefer to avoid investing in Class C buildings because they see them as riskier than Class A or Class B properties. This is because, as noted above, Class C properties are often in need of costly improvements and tend to draw lower-income tenants who may be less likely to pay their rent on time and in full each month. These two costs—major capital expenditures and late/non-payment of rent—can greatly impact the building’s net operating income.
The risk associated with investing in 'Class C' buildings
can be mitigated by investing with an experienced,
professional real estate sponsor.
For these reasons, many people will accept a lower return in exchange for the relative “safety” of Class A and Class B investments.
However, those who take this approach are often leaving money on the table. An experienced, professional real estate sponsor can mitigate the risk of investing in Class C buildings.
Multifamily sponsors who have a proven track record of upgrading Class C properties to better condition will know how to navigate any unexpected challenges that arise as they deploy their value-add strategy. Those who successfully mitigate risk are able to generate substantially higher returns on behalf of their investment partners (when compared to the returns typical of Class A/B properties).
Considerations When Investing in Class C Apartment Buildings
There are a few specific considerations to keep in mind prior to investing in a Class C property.
The first is that property class is always relative. Properties in one market should only be compared to properties in that same area. What constitutes “Class C” condition in Miami, for instance, may have very different characteristics of a Class C building in Cleveland.
Secondly, one should make strategic acquisitions of Class C properties. Investors should look for properties in high-growth markets (both job and population growth).
They should also further evaulate what other investments are being made in the area. For example, is there Class A construction going on? If so, where and what is driving this new growth and development?
When selecting a property, it’s crucial to consider the location first, since you cannot change the location of the property, even if you upgrade the building. Just because a property is a “good deal” doesn’t mean you should buy it.
Finally, it is important to base value-add improvements on what the market can bear. A common mistake that sponsors make is over-investing in Class C buildings. Often, the local demographic cannot support the high rents that the property owners need to achieve. Sponsors must strike a delicate balance; they must be careful not to over invest in a property to the point where local residents can no longer afford to rent those units.
At Smartland, one of our key strategies is to invest in Class C real estate that we then bring to Class B condition. We have a proven track record of deploying this strategy, and in turn, can proactively identify the challenges associated with a heavy value-add investment strategy. Our strategic approach allows us to deliver high-quality properties for local residents while simultaneously delivering strong returns to investors.