People use a lot of jargon when discussing commercial real estate. One of the most often cited groups of phrases is “Class A, Class B, and Class C” property. Someone might say, for example, that they invest in value-add Class B assets. They refer to a type of property distinguished by certain characteristics, such as its location, age, and condition.
Using “classes” is similar to assigning grades to properties. Just as a top-notch student might be referred to as an A-plus student, a property in premier condition will be referred to as Class A property. As you might expect, Class B, Class C, and even Class D properties are respectively less high-end as you move down the “class” spectrum.
While there is no universally accepted definition for Class A, Class B, and Class C property, there are general characteristics that one might expect for any property class. In today’s article, we describe the common features associated with each property Class. Many investors will talk about the “ABCs” of property, but today, we will expand upon this by looking at “Class D” property, which is an often-overlooked class that can be fantastic for investors who want to reposition and restabilize these buildings.
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Read on to learn more about the ABCs (and Ds) of commercial real estate property classes.
What Are Class A, Class B, and Class C property?
Class A Property
Class A buildings are usually considered to be a top-tier investment property. These properties are usually newly constructed and contain high-end finishes, materials, systems, and amenities. For example, a Class A property might be designed as LEED Gold or LEED Platinum, a designation that indicates the property has significant sustainable or energy-saving features. Class A properties will also sometimes contain unique architectural features. Depending on the type of property, the building might even have its own brand or lifestyle associated with it.
Class A properties are often located in the urban core, in downtown markets like Manhattan, Los Angeles, and Miami. They are often located near major employment centers, universities, hospitals, and arts and cultural activities. They will usually have good access to major highways or public transit.
Class A properties are sometimes referred to as “trophy assets.” They are highly desirable assets that attract interest from a wide swath of investors, including institutional and international investors. One of the reasons investors compete for these properties is that they have strong tenants. On the commercial side, this might include high-credit-worthy tenants and major corporations. This could include wealthy renters who are willing to pay a premium to live in these meticulous properties on the residential side. Given the demand from tenants, these properties often have stable cash flow and are considered relatively “safe” from an investor’s perspective.
Class B Property
Class B properties are a step down from Class A buildings. They are often 10 to 30 years old and may have once been a Class A property before newer buildings coming online. Class B properties are still usually well-located but, given their vintage, do not have the latest technology, amenities, and other features one would expect from a newly constructed property. They also require more in terms of repairs and maintenance due to their age. Systems may be due for replacement, and common area improvements, new facades, and landscaping upgrades might be warranted.
Class B properties still attract solid tenants. These might be more cost-conscious renters or businesses who are not ready to commit to a more expensive, long-term lease at a Class A building. Class B properties usually have strong cash flow and, with modest improvements, a strong potential for appreciation.
Class B properties tend to perform well regardless of where we are in any given market cycle. In a bull market, those previously renting Class C space will often upgrade to a higher-end Class B building. In a down market, renting Class A properties will often downgrade into a Class B property since it’s more affordable but still offers many features they had become accustomed to with Class A living.
Class C Property
Class C properties are usually older (30+ years old) and will often show visible signs of deterioration, such as overgrown landscaping or weathered facades. Since these properties are older, few will have modern amenities. Some will have no on-site amenities at all. Property and unit features are often outdated. The property might not have elevators, for example, or residential units might not have updated fixtures or desirable layouts.
Class C buildings are often located in less desirable locations. They may be farther from major employment centers or in areas with higher crime or few neighborhood amenities. On the residential side, the tenants often include those who cannot afford to live elsewhere. On the commercial side, tenants might be more start-up or cash flow constrained than tenants leasing space in Class A or Class B buildings.
Management tends to be rather intensive at Class C properties. Repairs and maintenance are routinely needed. Often, deferred maintenance leads to more costly repairs than if the owner had maintained the property throughout its lifespan. These properties also experience higher than average tenant turnover, which can create cash flow disruptions for investors. That said, the acquisition costs of Class C buildings are much lower than Class A or Class B properties, and when cash flow is steady, it can be very strong.
Class D Property
Class D properties are sometimes considered the black sheep of commercial real estate. These buildings are old, run-down, and often in need of significant repairs (if not widespread rehab). Many will have significant code violations or, worse, will have been condemned by the local municipality. Investors can often find class D properties in declining or otherwise dangerous neighborhoods. They are located in fringe areas, often far from necessities (like grocery stores and pharmacies).
From a management perspective, Class D properties are some of the most challenging. Tenants are often low-income with bad credit. Some may have criminal backgrounds or histories of eviction. Landlords will often have to chase these tenants for their rent payments.
Class D properties are the most affordable for investors to acquire, and those who do will find these properties have high rent-to-price ratios (at least on paper). In theory, Class D properties can have the highest cash-on-cash returns – assuming tenants pay their rent. Class D properties will rarely appreciate unless an investor makes significant capital improvements.
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Which Is the Best Investment Property?
Investors will often ask which class is “best” to invest in—but really, there is no right or wrong answer. All asset classes can be worthwhile investment opportunities. It all depends on an investor’s risk tolerance and preferred rate of return.
There is usually an inverse relationship between the property class and cap rates. Class A properties come at the highest price versus Class D properties, which are the most affordable. Class B and C properties fall somewhere in between. The risk level associated with each of these property classes also varies. Stabilized Class A properties are considered some of the “safer” investments compared to Class C or Class D buildings which are “riskier” investments. Accordingly, cap rates are lowest for Class A buildings and usually highest for Class D buildings. A Class A property might trade at a 3-cap, whereas a Class C or Class D building will often trade for well into the double digits.
Investors with a low risk tolerance will naturally be more attracted to Class A and Class B assets. This is why so many institutional investors are drawn to Class A properties – they are willing to accept lower returns in exchange for safer, stabilized assets that may appreciate over time. Those with a higher risk tolerance may want to consider investing in Class C or Class D properties. The latter will offer higher returns, but again, have a higher risk profile and rarely appreciate without significant investment.
The “Problem” With Classifying Property
There is an inherent problem with assigning property class labels to commercial real estate. The problem is that the class distinctions are all relative. For example, what is considered a Class A property in downtown Milwaukee might only be considered a Class B asset in downtown San Francisco. Tenants in San Francisco, for example, might have a different expectation for the quality, features, and amenities associated with a Class A property that simply does not yet exist in the Milwaukee market.
What is more, property classes can be fluid. A Class A property in 2010 may no longer be considered Class A just ten years later after several new buildings come online in that same submarket. These newer buildings will often have the latest technology and features, making the property built in 2010 seem outdated almost overnight.
The location also provides an outsized role in property classifications. For example, a multifamily building constructed in Boston’s Back Bay neighborhood might be 200+ years old, and yet, that might be one of the most exclusive addresses in town. Age and property amenities are often overshadowed when a property is otherwise well-maintained and incredibly well-located.
Finally, there are some instances in which a property is considered a certain class for reasons that have absolutely nothing to do with age, condition, or location. An example of this is when a Class C property has been poorly managed and, therefore, has a high vacancy, poor cash flow, and multiple pending evictions. The property might otherwise be in the upper C or lower B-class range if not but for the poor property management. Installing a new property manager and improved processes may be all that is needed to stabilize the property.
Pluses and Minuses of Property Classification
Now, let us layer in another element that only further muddies the classification waters. In addition to Class A, Class B, Class C, and Class D property grades, there are also pluses and minuses that are often associated with each grade. For example, a truly trophy-grade asset, such as a newly constructed office building located in downtown Manhattan, might be considered an A++ asset. Just down the street, another premier office tower might be considered an A or A- depending on its specific features. These are both high-quality office buildings, but the addition of pluses and minuses creates some distinction between them.
The same is true for Class B, Class C, and Class D property. A value-add apartment investor, for example, might purchase a Class C- building with the intent to bring it to B+ standards. Again, whether a property warrants a plus or minus really depends on local comps and market standards.
Final Thought on Class A, Class B, and Class C property
Property classifications are widely used but, unfortunately, are far from objective. A seller who is heavily invested in their property might assign a property grade to their building that others in the marketplace would rate differently. This is why property classifications should be used as a guide; investors should then do their own due diligence to determine how that property compares according to their own expectations and standards.
It is important to remember that there is no “good” or “bad” property class. Properties within each class can be lucrative, depending on someone’s investment philosophy.
At Smartland, we have a two-pronged investment philosophy. In the Midwest, we concentrate on Class D or Class C- investments that we then bring up to Class B condition – while including Class A features such as Alexa-operated lighting and sound and entry systems. Sometimes these properties are truly distressed. Other times, these properties are simply very tired and depressed. Our value-add investments include heavy renovations that improve unit layouts and features. Our renovations often add new amenities to buildings that previously had none.
Our investment philosophy in the Southeast looks a lot different. Here, in areas like Miami-Dade, it is more cost-effective to invest in ground-up developments. So in this market, Smartland buys land and builds new properties to a Class B+ standard or higher.
We are a testament that “class” alone should not be the sole driver of how someone invests. The specific geography and market conditions should always be factored in.
Are you interested in learning more about Smartland’s investment strategy? Contact us today to learn more about how our two-pronged approach creates opportunities for those with investment goals and risk tolerances of all kinds.