The type of property class a commercial real estate investor chooses can significantly impact the long-term stability and potential for growth of their investment.
For example, Class A properties are a good choice for those looking to preserve capital, while Class B and C suit those willing to take a higher level of risk in exchange for potentially higher returns.
New CRE investors often ask what the terms Class A, Class B, and Class C properties mean—and why these classifications matter.
Commercial real estate properties are classified based on a combination of geographical and physical characteristics.
The letter grades are assigned to properties based on factors such as the property's age, location, tenant income, the potential for growth and appreciation, amenities, and rental income.
These classes were developed by investors, lenders, and brokers to quickly communicate the quality and rating of a property, with each Class representing a different level of risk and return.
Investors can use this information to determine how each property fits into their investment strategy, including their desired returns and the level of risk they are willing to take to achieve those returns. There isn't a specific formula for determining the Class of a property.
Still, Class A properties are generally considered the highest quality, Class B is of moderate quality, and Class C is regarded as the lowest quality.
Class A properties are considered the best quality buildings in their market and location. They are usually newer constructions built within the past 15 years and feature top amenities, high-income tenants, and low vacancy rates.
They also tend to command the highest rent and have minimal deferred maintenance issues. These properties are usually situated in desirable areas and are professionally managed. Expect modern HVAC systems, eco-friendly building materials, and amenities such as parking garages.
Most Class A buildings also offer staffed lobbies, backup power generators, and high-speed internet.
Class B properties are considered a step below Class A properties. They are typically older, have lower-income tenants, and may or may not be professionally managed.
Rental income is usually lower than Class A properties, and some deferred maintenance issues may occur. They tend to be acquired at a higher CAP rate than Class A properties as they are considered riskier investments.
Class B properties in the office segment are considered "decent" and generally well-built structures with functional facilities. However, they typically have different high-end fixtures, architectural details, and impressive lobbies than Class A spaces, so they command lower market rents.
Most Class B buildings are less than four stories tall and are often located in suburban areas or on the outskirts of central financial districts. Additionally, Class B buildings tend to be older than Class A buildings and may show signs of wear and tear. As a result, some facilities that were originally classified as Class A may be downgraded to Class B after a decade or when signs of deterioration become evident.
Class B buildings are famous, with investors interested in renovations (usually improvements to common areas) to add value to these properties and bring them up to Class A status.
Many successful CRE investors use this business model and actively seek opportunities to upgrade Class B buildings to Class A.
One strategy is to find high-end Class B buildings in developing areas and add features that align with current market trends, such as live-work-play environments.
Developers also use vertical mixed-use development to convert commercial and industrial buildings into commercial and residential spaces. Again, they use their natural light, ventilation, and open floor plans to make conversions more desirable.
Overall, investors who use the buy-and-hold strategy may find that Class B properties, with their consistent cash flow and potential for long-term appreciation, are a good fit for their rental property portfolio.
Class B properties may become Class C in neighborhoods where surrounding properties could be better maintained.
Also, investors willing to take on a high level of risk and looking for properties that could experience a sudden spike in appreciation may be disappointed with the longer-term appreciation trend of Class B properties.
Class C properties are typically older—usually at least 20 years old and located in less-desirable areas. As a result, they often need renovation to update the building infrastructure to current standards.
Due to this, Class C buildings have the lowest rental rates compared to Class A or Class B properties in the same market. These properties may require significant renovations to generate steady cash flows for investors.
Class C buildings that are newly constructed often use inexpensive materials and have limited amenities, offering only necessities such as plumbing, heating, and electricity.
As a result, they are the most cost-effective to build and can also be affordably renovated if the building is in good condition, making them attractive to confident investors.
Class C buildings can be a suitable option for investors who are willing to take on more calculated risks in exchange for greater returns. Due to their typically being located in underdeveloped areas, these properties may have low appreciation potential.
However, if managed well, Class C rental properties can generate a good cash flow.In addition, the lower rental rates attract tenants with smaller operations that cannot afford more expensive spaces or do not require a central location for their business.
Other Class C buildings may be purchased as opportunities for rehabilitation. For example, with renovations and repairs, a Class C building can be upgraded to Class B, but it is unlikely ever to reach Class A status due to its location and age.
Class C properties typically have a lower purchase price and a higher level of rental income than the purchase price, resulting in steady and consistent revenue.
As a result, despite potentially higher repair costs, the net operating income, cap rates, and overall returns on Class C real estate can be higher than on Class B or A properties.
Management needs to be more hands-on to generate high cash flow from Class C rental properties consistently. Hiring a property management company with experience in Class C properties and tenants is often a good idea.
Obtaining financing for Class C real estate can be more challenging than for Class B or A properties, especially if the property has a significant amount of deferred maintenance.
Interest rates tend to be higher, and lenders typically require borrowers to have higher vacancy reserves to cover unexpected costs such as tenant turnover or repairs.
Investors should be aware that different property classes carry varying risk and return levels. Class A properties offer more security as they are typically considered top-tier and have minimal issues that would require additional investments. However, these properties may be more affected during economic downturns as they often rely on high-income tenants.
In contrast, Class B and C properties tend to have higher CAP rates as investors compensate for the added risk of investing in older properties with lower-income or lower-income neighborhoods.
It's essential to remember that commercial space classification is not an exact science, and many factors are taken into account, such as the state of the local real estate market and the amenities provided by the building.
As a result, these classes, while official-sounding, can be somewhat subjective.
Capital Investors Direct is quickly becoming one of the nation’s premier commercial real estate loans placement and advisory firms. We understand that every customer has unique goals, so we customize our services to meet each investment goal and objective.
If you’re looking for CRE financing in 2023, it’s best to cast your net wider and look beyond traditional lenders such as banks. Instead, start building relationships with private investors as early as now. Talk to Capital Investors Direct.
