As you develop your portfolio as a real estate investor, you are likely to encounter a number of concepts, terms and principles you don’t initially understand. One of the most common points of confusion for real estate investors are real estate class designations.
Understanding Class A, B and C real estate and using these class designations to select properties will help you optimize your portfolio, to reach your goals as an investor.
Property classification basics
Property classifications are designed to help investors determine the quality of a property with a simple, straightforward rating. These designations can help investors determine the costs, benefits and profitability potential of various properties.
There are three property classifications: Class A, Class B and Class C. These designations are assigned based on a number of factors including physical characteristics, market conditions and geography.
Class A properties are considered the best properties. Most Class A properties are relatively new and have been built within the last 15 years or so. These properties have high quality amenities, consistently low vacancy rates and high-earning tenants.
Class A properties are located in a desirable area with a high demand from prospective tenants. Because of the newness and quality of the property, as well as the appeal of the location, Class A properties usually have infrequent maintenance needs and bring in high rates of rent. A lot of Class A properties are professionally-managed and are already well-established as a quality property, with broad appeal to residents.
The next property tier is Class B. Class B properties tend to be a little older than Class A properties, with tenants that are lower earners than those at Class A properties. There may be some maintenance or repair issues in a Class B property, but investors can usually make improvements that make it a strong part of their portfolio.
Oftentimes, investors can also get a higher CAP rate from a Class B property because of their lower purchasing cost and their high potential for value increase through renovations, maintenance and repairs.
The last real estate designation is Class C. Class C properties are generally older properties that require renovations and upgrades before they can be made profitable. These properties are usually located in areas with lower demand and often have high vacancy rates and low rental profits, especially in areas where there are Class B and Class A buildings nearby.
The unspoken Class D property
There’s actually one more property classification: Class D. These are generally properties you want to stay away from. They’re considered severely run down, prone to devaluation and generally located in unfavorable areas. Class D properties are usually value traps and money pits—especially for new investors.
The only investors that should be looking into Class D properties are those with keen insight into future market trends, access to affordable rehab options and a wealth of cash readily available.
Which designation is the best choice for me?
Class designations indicate the current quality of a property, but don’t necessarily dictate its profitability potential. Depending on the circumstances, an investor might gain more from investing in a Class C property, fixing it up and marketing it to prospective tenants than they would investing in a Class A property outright. Investors can achieve higher CAP rates from Class B and Class C properties, which is also important to consider.
One of the most significant benefits of investing in Class A properties is the fact that you don’t have to put in a significant amount of work before it becomes profitable for you. In fact, many Class A properties are already in high demand and turning a consistent profit. High-earning tenants bring in higher rental profits, but it’s important to consider that market downturns can cause a significant increase in vacancy rates in these higher quality properties.
In general, Class A buildings are a good choice if you want to maintain your existing capital and hedge yourself against inflation. You can typically count on the reliable profitability of Class A properties and you benefit from the inflation resistance of real estate. If you are looking to cultivate value in your portfolio and develop a profitable property with a lower upfront investment, Class B and Class C properties are the right options for you.
Ultimately, your goal should be to own Class A properties, regardless of how you come by them.
Know the risk and reward
Each property classification has different levels of risk and reward. There is no single designation that’s right for every investor. You have to consider your existing circumstances and your long- and short-term goals as an investor so you can select property designations that make sense for your portfolio. Understanding these designations in relation to your investment circumstances is the best way for you to choose properties that are right for you.