The 3 Classes of Real Estate
Not all properties are created equal and one of the most common questions new commercial property investors have is the difference between varying classes of real estate. So how do classes of buildings differ and why is it so important for investors to know the difference between a Class A, B or C Property?
Commercial real estate buildings are generally marketed as being Class A, Class B or Class C properties. So what does this mean? How can investors tell the difference? And what does it mean when going into an investment over the short and long term?
Put extremely simplistically class is designed to make it easy for prospective investors to quickly recognize the current quality, condition and marketability of a property.
However, the difference is big. It can mean significant contrasts in tenant and structural quality, cap rates, returns and more. Contrary to some misconceptions a Class A property may not always be better than a Class C property. Grading depends on a mix and number of factors, but more importantly it is about what is the best fit for an individual investor’s portfolio and investment strategy.
Determining where a specific property falls on the grid may be a combination of age, appeal, look, functionality, location, tenant quality, access, rents and property condition.
How to Identify Varying Classes of Commercial Real Estate
Here is a quick guide to knowing your property classes:
Class A properties are generally newly constructed and identified as the most prestigious buildings in a given area. Rents are above average, tenants top of the range (including national credit tenants), finishes and amenities are high quality, and accessibility is good. These buildings also have their own clear market presence and brand. Think trophy assets.
The Building Owners and Managers Association defines Class B properties as suitable “for a wide range of users with rents in the average range for the area”. Assume “adequate systems”, fair to good property condition, with a mixed bag of tenants. These may have previously been considered Class A properties, and could potentially be restored to their previous grandeur with property improvements. In short, Class B properties are usually average in quality, don’t contain the same high quality finishes, amenities and architecture as Class A space but are functionally sound and usable. Also, Class B space is usually older than Class A space.
Class C properties are usually considered substandard in their respective markets. They may be run down, more than 20 years old, technologically and functionally obsolete for top grade tenants, in less desirable areas, in need of renovation and they offer the lowest rental rates.
Class C properties are usually in need of major repairs and renovations. Although with some improvements and repairs a Class C building can be upgraded to Class B, it is unlikely to ever achieve Class A status.
The Pros & Cons of Varying Commercial Property Classes
There are at least 6 considerations to keep in mind when choosing a property class to invest in:
1. Cap Rates
Returns can vary widely between property classes. However, this is perhaps most noticeable in advertised cap rates. Rates being lower on Class A properties, and commonly higher on Class C properties.
2. Tenant Quality
Obviously many top national credit tenants are going to gravitate towards Class A space, while new startups and the budget sensitive head for the lower rents of Class C. However, even though high speed internet service such as Google Fiber may be helping to contain great tenants in top business hubs, business tenants and their teams are increasingly becoming less dependent on location. Similarly big brand name tenants might appear to promise higher rents and consistent cash flow, but are also tough negotiators and their demands also increase operating costs.
One of the factors many new commercial real estate investors may not foresee is the impact of class on leverage. Many mortgage lenders will separate property by Class A, and everything else. Common sense says rates, LTVs and terms will be more attractive on Class A.
4. Additional Investment
Going into a Class C property may clearly require additional investment improvements due to property condition. However, in terms of total dollars expended for such improvements, the amount may be no less than on Class A due to the higher standards expected by tenants occupying such buildings.
5. Growth Potential
The cap rate may highlight the difference in cash flow. Yet, according to analysts and experts reporting via the CCIM Institute, many global investors are increasingly chasing Class C properties for their superior growth potential, higher stabilized cash flows and because Class C properties generate less competition.
A part of the enhanced gravitation towards Class C properties definitely appears to be a result of increased confidence in the outlook for the market and willingness to take on risk that was unpalatable a few months ago.