One of the biggest reasons individuals avoid investing in commercial real estate is the belief that it is overly complicated. Each transaction may have a unique product type, property class, and project type.
Commercial real estate as an asset class encompasses a wide range of product types, including multifamily, office, industrial, hospitality, retail, and land development.
Each product can be further classified by property class (Class A, B, or C), which is determined by the property’s age, location, condition, and amenities.
Then there’s another layer to consider, known as the project type. In general, there are five project types:
Core (stabilized properties that bring in money and are usually in primary markets).
Core-Plus (Properties in primary or secondary markets that aren’t making enough money).
Value-Add (Properties in primary, secondary, or tertiary markets that are ready to be fixed up or renovated).
Opportunistic (One of the riskiest types of projects, opportunistic projects already have little or no cash flow).
From the Ground Up (turning land into any kind of product).
Trying to make sense of these intricacies might be intimidating for a rookie investor. Which product, asset class, or project type is the best to invest in? There is no correct or incorrect response; it is dependent on a person’s risk tolerance, investment horizon, and overall financial goals.
Some sponsors will concentrate their efforts on investing in Class B / C, Multifamily Value-Add possibilities, to maximize investor returns by refurbishing these properties to one class higher than when they were acquired. Other sponsors will use the same technique but will convert Class B assets to Class A, and so on.
This post will walk you through a multifamily investment analysis and compare Class A, Class B, and Class C real estate. Before participating in a deal, any prospective investor should grasp the differences between these asset classes. Continue reading to find out more.
What Exactly Is Multifamily Real Estate?
Simply put, “multifamily” real estate means “apartments,” but the term goes far more profound. Many people associate “commercial real estate” with office buildings, retail properties, and similar structures. Not everyone realizes that housing might also fall into that category. One example is multifamily housing, while elders and student housing are two more.
Multifamily real estate is a subset of commercial real estate. The word “multifamily” is commonly used to distinguish this housing style from single-family homes, condominiums, townhouses, and other types of housing typically owned by one person and utilized by one household.
Multifamily real estate can take many different shapes. It is the simplest form of multifamily housing, a two-unit, which includes two apartments in the same building under the same roof, sharing common systems like the HVAC, plumbing, and electrical (though these can be individually metered with costs charged back to the tenants), and always sharing either vertical or horizontal common walls, either side-by-side (for up-and-down units).
A frequent method for first-time investors is to purchase a small multifamily property, such as a duplex or four-family house, and live in one apartment while renting out the other (s). One advantage of doing so is that the owner can secure the most advantageous bank financing when the property is owner-occupied. First-time investors can also learn the “laid of the land” while becoming landlords.
However, the definition of multifamily might be much broader. Large apartment complexes, for example, can easily have 200+ units spread across numerous buildings, with or without a variety of on-site services. Larger multifamily apartment complexes, especially downtown high-rises, are often purchased and operated by more sophisticated investors such as life insurance companies and pension funds.
What Exactly Is an Asset Class?
An asset class is a collection of investments with comparable characteristics that react similarly in the market. Equities, which include stocks, bonds, and money markets, are the three “conventional” asset types. Real estate and commodities are two other asset types that are occasionally referred to as “alternative assets,” but both are becoming more mainstream.
People frequently use the term “asset classes” in commercial real estate to differentiate between different types of buildings. What they’re really doing is distinguishing between property classes: Class A, Class B, and Class C. This is because real estate is the asset class, and there are other property classes inside that asset class. Yes, it’s perplexing, but it’s a crucial distinction to make.
The real estate “Class” system was developed to describe the features of a possible real estate investment simply. Classes A, B, and C are determined by a mix of physical, regional, and demographic factors. Each class indicates a distinct level of risk and reward.
What Are the Various Multifamily Property Classes?
As previously stated, multifamily real estate is divided into three “classes”: Class A, Class B, and Class C. We’ll go through each of these in more detail below, but in general, Class A is the nicest (and most expensive) of the lot, with more facilities, better locations, and tenants with higher credit ratings. Class C homes are typically older, have fewer facilities, are less conveniently located, and are in need of refurbishment. Class B multifamily properties are in the middle.
Investing in each multifamily class has advantages and disadvantages. Class C buildings, for example, are the cheapest and most accessible to regular investors wishing to acquire commercial real estate. These are, nevertheless, the most sensitive to market downturns, such as those experienced during the Coronavirus epidemic, when unemployment surged, with working renters in Class C buildings bearing the brunt of the impact.
Class C properties might be diamonds in the rough that require considerable physical modifications or improvements to continuing commercial activities such as management and marketing. Class C properties are becoming a popular commodity in the realm of multifamily construction as housing and property values continue to rise in many parts of the United States.
Class B homes frequently have excellent bones but have been neglected and merely require a makeover to be upgraded to Class A status or to raise rents to market levels. Meanwhile, residents in Class A houses have more stable jobs and higher credit scores. Larger Class A properties are more likely to attract institutional buyers, providing sponsors and investors greater exits.
Class A Multifamily
Most people think of Class A multifamily investment properties as one of the “safest” investments in terms of risk. One reason for this is that Class A properties are usually in good locations in primary markets and areas with strong economics. Most of these places are near major employers, universities, hospitals, and places for arts and culture. Most of the time, they will be close to highways and/or public transportation. In other words, these are “safe” ways to invest because Class A multifamily buildings are usually in places where people want to live.
The condition of Class A properties is another thing that sets them apart. Many Class A buildings are brand new, with high-end finishes and a lot of amenities for tenants, but this isn’t always the case. Class A properties do not have to be brand new. A Class A building could just as easily be an old building, maybe even a historic one, that has been gutted and fixed up to be on par with new buildings.
Class A properties usually have high rents because of their location, condition, and amenities. This gives them a strong cash flow. Most of the time, these properties will be in high demand from a wide range of investors, including institutional investors and investors from other countries. This can make prices too high for the average investor to afford. Even when the market goes up and down, it’s usually just as easy to sell a Class A property as it is when the market is steady.
Class B Multifamily
Class B apartments are one step below Class A apartments. They tend to be a little older or not in as good of shape. They could be on the edge of the main market, like a submarket on the edge of a city center.
Most Class B properties have higher maintenance costs than Class A properties, which smart investors will want to take into account in their pro forma before investing. Class B multifamily homes may need minor repairs, upgrades to common areas, system replacements, new facades, or better landscaping. Most Class B properties will have third-party management that is at least good, if not professional.
Class B properties usually have fewer amenities than Class A properties, like on-site gyms, doggy daycares, storage lockers, covered parking, movie rooms, and outdoor pools. As a result, the rents for Class B properties are usually lower. Even though this is the case, these buildings still tend to get good, stable tenants, even if the overall vacancy rate is higher than what you would expect in a Class A building.
Class C Multifamily
Class C buildings can be profitable investments for people who know how to do it right, but they are not without risk. In fact, Class C properties are thought to be the riskiest of the three types of properties we’re looking at today.
One reason for the extra risk is that these buildings are usually 20 years or older and need a lot of repairs. Many of them will have obvious signs of deterioration, like overgrown landscaping or building facades that are falling apart. Because these places are older, they usually don’t have many or any on-site amenities.
Most of the time, they are older buildings, often more than 30 years old, that haven’t been updated or renovated much in recent years and still have the original appliances, wiring, plumbing, etc. Many Class C properties are in bad shape and have major structural and livability problems because they don’t get enough or enough regular maintenance.
Class C properties are often in low-income areas that aren’t as desirable. In these areas, crime rates tend to be higher, and infrastructure like schools, job opportunities, and amenities are often not as good as in more desirable markets.
Class C properties are often priced lower than Class B and Class A properties because of the problems listed above. Many, if not most Class C properties will require a significant amount of money in the beginning to get them running properly. These costs include things like renovations and physical maintenance, as well as things like marketing the property, finding new tenants, and so on.
The risk is increased because most Class C multifamily buildings are in less attractive places. They may be farther away from major job centers or live in dangerous areas with few grocery stores, pharmacies, restaurants, parks, and playgrounds nearby. Most of the time, people live in Class C buildings because they are cheaper than other options.
Class C buildings are riskier because they’re in less economically developed locations and have unstable tenants. They also often require a lot of money to get started, and delinquencies, higher crime rates, or more vacancies caused by tenants who don’t want to stay there can add to the risk of a project.
Class C properties can be great investments; investors just need to be careful and use their experience to ensure success, which leads to our next point. Class C properties have the best possibility of producing money among the three. This cash flow is not easy to get because these buildings are often hard to run.
Some properties won’t be able to make money right away, and you’ll need to take some time off to fix them up. This will make it take longer for the property to start making money. Investors in Class C properties should expect this to happen and plan for it in their financial forecasts.
What Factors Affect How A Property Is Categorized?
Among the things that affect how a property is classified are its location, age, condition, amenities, and the number of people living there. Each of the “rules” below almost always has an exception, so you should consider their general guidelines.
Location
A property’s location is a critical consideration for determining its classification. As was already said, Class A properties tend to be in the best places. These homes will be close to major employers, hospitals, universities, shopping, restaurants, and other arts and culture amenities. Most of the time, but not always, they will be in places with good schools and low crime.
This is because some Class A properties are in highly desirable urban areas where the school districts might not be as good as those in some nearby suburbs. Still, many people who live in Class A multifamily buildings will choose to send their kids to private or charter schools instead of the school district they live in.
Most Class B and Class C properties are in areas that aren’t as nice. For example, Class C properties are often in low-income areas that aren’t as desirable. In these areas, crime rates tend to be higher, and infrastructure like schools, job opportunities, and other amenities often lag behind more desirable markets.
But this doesn’t always happen. A Class B or Class C property, which is based on its age, condition, or lack of amenities, maybe in a great location, but the building itself leaves a lot to be desired in other ways.
Age of Building
The age of a property with more than one unit will also affect how it is categorized. Class A buildings are usually newer than Class B and Class C buildings, which are usually older. Most Class C properties are at least 20 to 30 years old.
This “rule” is broken again, though. Even if a building is older, it can still be considered Class A if it meets the other requirements listed here. Older buildings are often completely remodeled to have the same high-end finishes and features as new buildings. Age alone can’t tell you what class property is in; you also have to look at the other factors.
Condition of the Property
The state of a property is one of the most important things that determine its class. A property that has been fully remodeled and updated with high-end finishes is more likely to get Class A status than a multifamily property that is old, worn, and in need of both cosmetic and structural repairs. Class A and B buildings usually need less maintenance than those in Class C because they are in better shape.
Amenities
Most of the time, Class A properties have good amenities. This could include a fitness facility, media room, concierge, underground or otherwise covered parking, outdoor pool, pet daycare, and other amenities in the multifamily commercial real estate field. The amenities at an apartment complex tend to be better the bigger it is. Most Class B and Class C properties have fewer amenities if any at all.
Occupancy
Occupancy is a key part of figuring out the property class. Class A properties tend to get the best tenants, who are usually professionals with high incomes and good credit scores. Class A buildings are popular with many people, so they typically have very low vacancy rates. Class B and C properties tend to have less desirable tenants (people who make less money and have lower credit scores) and may have more fluctuating occupancy rates.
There are, of course, times when this rule doesn’t hold true. Professionals with high incomes who care more about price than their peers may also be interested in Class B and Class C properties. People often rent Class B and Class C apartments, which are less expensive, while they save up for a down payment on their own home.
Other Things to Think About
Types of Residential Rental Property
“Residential” rental property is distinct from “commercial” multifamily property, which we discussed briefly above. Residential rental properties can have anywhere from one to four units. These include single-family homes, condos, and townhouses that someone buys and then rents out to someone else.
For lending purposes, these properties with one to four units are all in the same category as single-family homes. This means they are not in the same category as the commercial products we are discussing today.
So, even though properties with two to four units are called “multifamily” because there is more than one apartment in the building, buildings with four units or less are usually called “residential” rental properties because a residential bank can finance them.
Commercial debt is required for properties with five or more units. Most of the time, the terms of a residential loan are better than those of a commercial loan, which are usually at least 50 basis points higher than the rates quoted for a residential property.
What Are The Possible Risks Of Each Investment Option?
As with any investment, real estate or not, some risks come with each “class” of multifamily real estate. Some of these risks are:
Class A: The biggest risk of investing in Class A is that there are too many of them
During real estate cycles, when the market gets better, the price of land and the cost of the building go up. As the price of land rises, the only way to make a contract “pencil” is to base it on rising rents, which usually means assuming Class A rates.
This means developers can only stay in business by building Class A apartment buildings. This causes an oversupply and a rent drop when the market goes down.
There is also a risk during boom times. Since luxury tenants can often buy their own homes instead of renting, you risk falling behind rising housing prices when times are good. During the recent COVID-19 pandemic, we saw this happen a little bit, as wealthy renters fled to the suburbs, leaving luxury apartments in dense cities empty.
Class B: The threat of competition is one risk of investing in Class B real estate
If a lot of new Class A multifamily housing comes on the market, it could push the existing Class A housing into the Class B category, making it harder to find Class B housing. A second risk of investing in Class B multifamily is that the investors might not have enough money to keep the property in good shape as it ages or to carry out their business plan to make the property Class A, if that was ever the goal.
Some of this risk can be reduced by choosing the right location, but at the end of the day, you’ve got to attract the right tenants. Without the best amenities or the best location, that can be expensive, time-consuming, and a little scary when you’re not looking at the same gains from forced appreciation that you might see with a Class C property or the best tenants that you might find with a Class A property.
Class C: The two biggest risks of investing in Class C real estate are the cost of repairs and maintenance over time and the less stable tenants’ credit and jobs
Most of the time, these buildings need the most work and could stop working if the owner doesn’t put in the money they need. Second, Class C tenants tend to have lower earnings and are more likely not to pay rent (and be evicted as a result). This can be especially bad during economic downturns when people are more likely to not pay rent and be kicked out.
Most people who live in Class C buildings are lower-paid workers who are more likely to lose their jobs when the economy as a whole goes into recession. Class C properties have lower rents than Class B properties with similar features and won’t have as many amenities as Class A or B properties.
Many times, forced appreciation makes it hard for new investors in Class C properties to make money. Forced appreciation refers to the steps that individual investors take to increase the property’s value, such as making repairs, putting a business plan into action, marketing the property better, reducing vacancies, etc. This is different from natural appreciation, which is how much the property’s value goes up because of market forces.
Managing any Class of property can be hard, but managing a Class C project on your own can take a lot of time. Investors who want to profit from Class C properties but don’t want to do the labor-intensive work can engage a management company. Still, an intelligent owner won’t put all of the control of a property in the hands of a third-party management company. Instead, they will be involved in some way, especially when finding ways to improve the property and make it safer.
What Are The Possible Benefits Of Investing In Each Category?
We’ve talked about some of the benefits of investing in multifamily real estate in general, but each property class has its own benefits, such as:
Class A: These are usually the nicest and newest homes, so they tend to need the least amount of maintenance
Class A multifamily properties also tend to attract the best renters, like people who make six figures and are willing to pay more to live in these nice places.
When you buy a Class A property, the appliances, fixtures, and building features will be newer because the tenants are pickier. This means your repair and replacement costs will be lower, at least at first.
Since Class A properties tend to be in good neighborhoods, a lot of your initial research has already been done, at least in terms of checking out the neighborhood.
You can expect these properties to be in places that are easy to get to by public transportation, such as neighborhoods that are easy to walk through or that are close to job centers or shopping and retail areas.
Also, when (or if) it’s time to sell, you’ll likely have a much larger pool of buyers looking to buy the property. Many investors ignore B and C properties and focus only on Class A because they don’t want the extra risk or the work needed to make potentially higher returns. Either way, it makes it easier for you to sell when the time comes.
Class B: The main benefit of investing in real estate in Class B is that these properties tend to be very stable through changes in the economy
In an upmarket, Class B multifamily properties attract a wide range of renters, including those who could afford Class A real estate but are more cost-conscious and those who earn less but are willing to splurge on the extras that come with a Class B property. When the market is bad, Class A renters often leave their apartments and move into Class B ones to save money.
Another benefit of Class B real estate is that if the property is in a good spot, it can often be fixed up to be in Class A condition with some thought. Class B leases average 10 to 20 years; however, this is not a norm. Class A properties usually become Class B after a certain amount unless they are constantly renovated and updated. The cycle usually goes Class A to Class B to Class C, but this is not set in stone.
Few repairs have been put off on these properties, so they are in good shape. Most of the time, the property’s finishes and fixtures are above average, but they aren’t always brand new. They are in neighborhoods where most people are middle class or working class. The schools are above average, and there isn’t much crime. All of these elements create a “Goldilocks effect,” where you obtain Class A benefits without the higher cost.
Class C: The best thing about a Class C multifamily property is that it is the most affordable of all the property classes, so it appeals to the most investors
First, Class C properties are often sold at low prices, which can be a godsend in many cities with high living costs where prices have grown so high that many investors can’t afford them.
This means that investors can buy more apartment buildings that have the potential to make more money than other types of apartment buildings.
Investors can get more cash flow from a Class C property than from a property in a different class that costs more to buy, maintain, and run. This is because Class C properties are often opportunities to add value, have low acquisition costs, and have a high chance of making the business more profitable.
Since it costs less to buy Class C properties, it can be easier to take advantage of economies of scale with a portfolio of Class C properties.
They can often benefit from forced appreciation, which is when investors and developers add value to a project to increase cash flow, lower vacancy, and increase the total value of a property. There is usually more room to add value to a Class C property because it can be upgraded to a Class B or even a Class A property, as long as the neighborhood can handle it. Class A properties, on the other hand, don’t have much room to go up in value and are usually bought only for their yield.
Since Class C properties cost less to buy than those in Classes A and B with the same features, and because they often need more layers of management to stay stable, their operating costs can be higher.
This can lower relative returns, but overall, Class C properties are less appealing to investors and are of little or no interest to institutional investors. Because of this, cap rates are usually higher, which means investors will get higher yields.
They have more room to grow in terms of both rent and occupancy, so the chance to make more money on capital gains can be bigger than in Class B or Class A, where there may be less room to grow.
Class C might be a good place to start for someone who wants to buy a multifamily home for the first time. They can improve the property over time, maybe getting it into Class A or B condition, and then sell it for a profit. The investor can then use the profit to buy a nicer, newer multifamily property if they want to.
Can The Class Of A Property Change?
The class of a property can change. In fact, some investors buy Class B and Class C value-add multifamily apartment buildings on purpose with the plan of doing a lot of work to bring them up to Class A condition. For example, a Class B property may be in a great location, but the current owner may not take care of it as well as they should. This property might be able to meet Class A standards with a little TLC and a lot of new capital.
Remember that property classes are meant to help you figure out what to do. The homes in the area have a big impact on the property class.
Let’s look at a 250-unit apartment building that was built in 2014 in downtown Los Angeles. Most investors might have thought that building was a great investment. But in the last few years, a lot of new apartments have been built in Los Angeles. Now, this 250-unit property is in high demand.
Its rivals are newer, have more modern amenities, and are more appealing to a wider range of people. People start to move out of the 2014 building and into the nearby towers that look better. Once thought of as Class A, investors in the area may now think of the 250-unit property as Class B. With a simple update, the property could be brought back up to date and compete with its new rivals.
What Kind Of Property Is Best For Your Portfolio?
Not sure which type of property to buy? You aren’t alone. The amount of properties you add to your portfolio depends on your risk tolerance.
It can be tempting to buy a Class B or Class C building with the goal of fixing it up to Class A standards, but this is not an easy task. This strategy should only be used by the most skilled investors or those who have teamed up with real estate developers who have a lot of experience because it is riskier and could require more money up front.
Still, people with a good plan for fixing and stabilizing a property will find that Class B and Class C properties usually trade at higher cap rates and make more money than Class A buildings.
When looking at different investing ways, you should consider where the property is. The only thing that can’t be changed about a property’s classification is where it is. You can fix a property, add amenities, and get more people to live there, but you can’t change its location.
Top Multi-family Real Estate Markets
You can talk about the “best” markets for multifamily real estate in many ways. For instance, some investors might judge a market based on how likely it is to grow over time. Others might think about the cap rates in a particular market.
Even people looking at cap rates might disagree on a “top” market. Some investors may think that markets with low cap rates (3-5 percent for multifamily housing) are the best places to put their money because these areas are usually well-known and have high rents (but as a result, high purchase prices and by extension, high barriers to entry). On the other hand, some investors like markets with high cap rates (10% or more), which can signal value-add opportunities.
How someone figures out which markets are “top” depends greatly on how they invest. People with a long-term, “buy and hold” mindset might look at market opportunities differently than those with a shorter-term, “value-add” mindset.
Here Are the Best Markets Based on Several Characteristics
Austin
Austin, TX, has been a favorite in the multifamily real estate market for many years. The metro area continues to grow, with solid job growth and more people moving into their own homes. This has kept the demand for all types of multifamily housing high. Compared to other markets, multifamily housing in Austin tends to be fairly cheap, but it still gets strong rents from a wide range of tenants.
Atlanta
Atlanta is another market that keeps growing, so there is still a strong demand for multifamily housing. This is true both in the city center of Atlanta and the suburbs. Atlanta’s neighborhoods are diverse, which makes it a good place to invest in both Class A high-rise buildings and smaller, garden-style apartment communities in the nearby suburbs.
Phoenix
Due to the economy’s continued growth in the area, Phoenix is considered one of the best places to buy multifamily housing, along with Austin and Atlanta. Hundreds of new people move to the state every day to take advantage of new job openings. Also, the building of new multifamily homes hasn’t kept up with the demand, so there’s a lot of pent-up demand for rental housing, which is making prices go up.
Boston
CBRE, a national real estate advisory firm, says Boston is still one of the best places for multifamily housing. It may surprise some readers. Boston’s population isn’t growing like the markets above, but the area has world-famous hospitals and universities that help the economy stay strong during recessions. The land is also limited in the area, which makes it hard to build new multifamily homes. Because of this, existing rental properties tend to keep their value even when the market changes.
Arlington, VA
Investors in multifamily homes are now paying attention to Arlington, mainly because Amazon said it would move its “HQ2” headquarters to Crystal City, a neighborhood in Arlington. This is expected to give the area thousands, if not tens of thousands, of new jobs. The site already needs a lot more multifamily housing, so this is great news.
Conclusion
For many reasons, individual investors have always had difficulty getting into commercial real estate. The main reason is that it requires a lot of money. You often have to spend a lot of money to participate in a real estate project. Accredited investors can work with companies that crowdfund their syndications more and more. This lets them pool their money and then use it to buy a portfolio of real estate assets. This method appeals to investors who can’t or don’t want to purchase commercial real estate independently.
But investors shouldn’t just put their money with third parties
Instead, potential investors should carefully consider (a) the experience of their investment partner, not just in terms of how long they’ve been in real estate but also how many downturns they’ve been through; (b) their partner’s investment strategy, whether its ground up, value add, core, or core-plus; (c) their partner’s transactional experience in terms of dollars; the more, the better; and (d) the terms of the deal and whether the sponsor and their interests are aligned.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.