When speaking to investors you may often hear an alphabet soup of acronyms or codes. In this quick tip article, we will demystify the terminology behind the various property classes. We will also provide some general comments on the typical business strategies operators tend to follow with each property type, so you can then form your own view on what you are comfortable with as you refine your own investment strategy and approach.
There are four classes of properties: A, B, C, and D. Each class represents a different level of risk and return.
Class A (aka Core). These properties are new (built in the last 10-15 years) or represent Class B properties that have been substantially renovated and updated. The properties are of the highest quality and boast modern construction (will often have the latest technology package and energy-efficient systems). As such, these properties have the lowest amount of deferred maintenance. Class A properties have premium and several amenities (gym, dog park, office, community room, pool, spa, etc.) They are in excellent locations often close to good school districts or hip locations and high-income-low crime areas. The tenant base is white-collar or high income. These properties command the highest rent. Because of this, they are more sensitive to recessions and it would not be uncommon for some of the tenant bases to transition to a Class B property during a recession.
Based on the above, Class A properties have a higher purchase price and as a result, lower cash on cash return and lower but more stable cash flows. They also have the greatest potential for appreciation and the lowest level of risk. Cap rates tend to be the lowest as result.
Class B (aka Core Plus). These properties were built in the last 15-30 years. Construction is generally of good quality and may be brought up to a Class B+ or Class A level after substantial renovation and modernization and thus, opening an opportunity for forced appreciation via value add updates. They have some deferred maintenance and fewer amenities. They tend to be located in stable neighborhoods and moderate-income and low to moderate crime areas. The tenant base is a mix of middle-income professionals and higher-earning blue-collar workers. Rents are moderate.
Based on the above, Class B properties are less expensive than Class A properties and as a result offer moderate cash on cash return, moderate cap rate, moderate to high appreciation, and moderate risk.
Class C (aka as Value Add). These properties were constructed within the last 30-50 years. The buildings have average to low functionality and are typically outdated and in need of remodeling. They have much more deferred maintenance and limited (if any) amenities. Catching up on the deferred maintenance or substantial updates may bring those properties to Class C+ or B- condition, thereby creating an opportunity for forced appreciation. Class C properties are located in lower income-moderate crime areas but opportunities may be found in Class C properties located in Class B areas. Rental rates are low to moderate. The tenant base typically comprises blue-collar/working class households. Turnover and vacancy tend to be higher.
Based on the above, Class C properties are less expensive than Class B properties and as result, offer higher cash on cash return, higher cash flow, low to moderate appreciation, and pose a higher risk. Cap rates tend to be higher than those of Class A and B properties as a result thereof.
Class D (aka as Opportunistic). You may often hear those described as war zones. These are the roughest properties one can encounter. They are constructed in the last 30-100 years. They are often in poor condition and plagued with much-deferred maintenance and as such, are often obsolete with poor and outdated construction and materials and no amenities. Class D properties are located in the roughest part of town marked with violence, drugs, and prostitution. The tenant base is low income and may have a criminal record.
Based on the above, Class D properties would be the least expensive and the riskiest and as a result, will offer the highest cash on cash return. Cash flow may be volatile. Even if upgraded, based on the property location, they will rarely appreciate in value and essentially have no exit plan. They represent the highest level of risk.
Which property type you select in the end will depend on your investment parameters around acquisition costs, risk tolerance, business strategy, and desired returns.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.