While properties don’t always fit neatly into well-defined categories, real estate investment professionals have established some broadly-accepted real estate property classifications that help them quickly discuss the general condition and features of a potential real estate asset. Once you become comfortable with the terminology, you will have a much easier time conversing with others about real estate investment opportunities that you are considering.
These are also helpful because, as an investor, you can save time viewing only the properties that match your risk and reward preferences. Depending on your available capital, investing timeline, and cash flow needs, these classifications allow you to more precisely target properties that best fit your ideal investment profile.
In this article we hope to give you an understanding of each of the four property classifications and provide insight into which class is right for which investor.
The class A, B, C, and D system
There are a few different systems for classifying commercial real estate, but one of the most common involves four broad categories (classes), ranging from the letters A to D.
If you’re a new investor, you would probably assume that they follow the same letter-grade format as schools: A is the best, and D is the worst. But this is investing, not high school. Depending on your situation, a class B, C, or D property could be a better investment for you than a class A property.
Each category carries a different set of risks and returns based on factors such as location, age, rental income, or anticipated appreciation. For example, a commercial property with a class A location could carry a B classification overall because of its advanced age and/or need for extensive repairs. All of these factors must be taken into account holistically when classifying a property.
At Birchstone Investments, we primarily specialize in class B and C properties, as they offer the optimal balance of risk and reward for our investors.
The four commercial real estate property classifications
Class A Property
Class A investment properties are the highest-priced. They are typically newly built — ten years old or less — and benefit from low vacancy rates while still demanding the highest rent. Since they’re newer construction, they tend to have little-to-no maintenance issues.
Class A properties are in desirable locations that boast measurable economic growth, job opportunities, and well-established infrastructure. They have top amenities and are usually professionally managed (they may even have a homeowners’ association).
Potential Upside: Very much in demand, class A investment properties are considered to carry the lowest risk as they have fewer expected maintenance issues and expenses.
Potential Downside: Class A properties may provide a lower amount of cash flow due to high demand for a more hands-off investment increasing their purchase price. You can expect to pay top dollar.
Compared with other classes, a class A property’s ceiling for appreciation can be limited. Put simply, the nicest building in town in the nicest area likely has little room to grow. For instance, if you are already using the highest-grade appliances and fixtures, there are fewer upgrades you can make to further add value to the home. New developments or infrastructure additions in the surrounding area are unlikely or unnecessary, which means the location is unlikely to gain a higher land value or appeal than it already has.
Lastly, if you’re dealing with a luxury property, it could be more vulnerable to a recession than other classes. The highest rents can be hard for companies or individuals to afford in an economic downturn.
As mentioned previously, we tend to avoid class A properties, because they promise less-than-desirable upside — despite being a relatively safe bet.
Class B Property
These properties are similar to class As in many respects, though slightly lower in quality. Class B structures are usually older, may have some required maintenance on the horizon, and lack some of the amenities that you typically find in class A properties. You can expect to collect less rental income than with a class A property. Although they still tend to be in popular locations, such as middle-class areas, that still have room for significant appreciation.
Potential Upside: There’s some room to grow. Class B properties appeal to investors who are looking to renovate and improve units and common areas to increase their value. This is known as “forced appreciation” (we’ll cover this in-depth in another blog post). You can look at class B properties as those having lower upfront costs but great potential for steady cash flow and appreciation over time. They often have a lower asking price than class A properties.
Potential Downside: These properties are somewhat riskier than class A assets. While likely well-maintained, an investor must spend money to improve their appreciation, making them less of a turnkey operation as class A. Any improvements will require investor capital, and there is always a risk a construction project stalls or doesn’t pan out according to plan. Although, some of that risk can be mitigated with proper analysis, due diligence, and project management.
Class C Property
Generally over 20-years-old and located in less desirable locations, class C investment properties are often in need of considerable renovation (e.g. plumbing, electrical systems, and more) along with other infrastructure needs. They tend to have lower rental rates compared to classes A and B.
Potential Upside: Lots of room to grow. Class C assets can be attractive investments in that they have lower acquisition costs along with the opportunity for a high cash flow once renovations are complete. Improvements to infrastructure and new developments in the area could raise the land value, also improving appreciation. Investors with patience, experience, and market knowledge can find value in this class.
Potential Downside: Class C assets are riskier than A or B properties. More work may be needed for a longer time period before investors see steady cash flow, and appreciation is not completely guaranteed.
Class D Property
Class D properties typically need a significant amount of repair and renovation work and in many cases are uninhabitable until such work is completed. They are most often in undesirable locations, such as city neighborhoods with bad reputations and/or boarded up buildings. We tend to avoid class D investment properties at Birchstone.
Potential Upside: These are the least expensive properties, and they carry high potential for appreciation.
Potential Downside: These are the riskiest properties. And because they are often found in undesirable locations, it could be difficult for investors to attract reliable tenants, even after improvements.
Due to the extensive amount of work to bring these properties in shape and turn a profit, they tend to be acquired by experienced investors who understand the market area well.
Which property class is right for your portfolio?
Commercial real estate property classifications give investors a quick reference for understanding a property’s condition as well as represent varying levels of risk and reward. Like most investments, there’s more risk when going after higher returns and less risk with modest returns.
As you decide which class is right for you, consider your long-term and short-term investment goals, working capital, and risk comfort. And of course review offering materials for any class of property carefully.
If you’re struggling to figure out which property class suits your needs best, we’d be happy to chat. Contact our team for more information.