The ABCs of Neighborhood and Property Classes

If you've started looking into multifamily investments, you will quickly hear about property classes. Investors you talk with may say "I have a great class A property in a class A area" or "I only invest in B properties," but what are they talking about? In this article, I'll cover what these mean and how you can determine the class of a property or area.

Property Classes

The first thing to note about property classes is that there is no strict definition for each class. There are general guidelines that people agree on, and that I will cover below, but ultimately a property's class is subjective. The most common classes are A, B, C, and sometimes D, and you may see a property class listed with + or -, like a B+ property. Let's start with class A.

Class A

These properties are the nicest properties in desirable areas of the market, and sometimes called "luxury" apartments. They are newer construction, often built within the last 10-15 years, though it is possible for a recently renovated older building to be in this class. Since they are newer, there is little to no deferred maintenance and no need for large renovations. Class A properties attract white collar workers who choose to live there due to the location and high-end amenities, such as a resort-style pool, state-of-the-art gym with fitness classes, and luxury finishes in the apartments. Because of these amenities, these properties command the highest rents in the market.

From an investment standpoint, these assets usually provide higher appreciation and lower, but stable, cash flow than other properties. Vacancy rates are also usually lower. Most of these properties are professionally managed and attract better terms from lenders since they are less risky. However, there is a risk of higher vacancy in a recession as high-income earners lose their jobs and are forced to downsize.

Class B

Class B properties are older than class A, at around 10-25 years, with some deferred maintenance. Since they are older, they have dated exteriors and interiors that could be renovated to add value to the property. There are also fewer amenities than the higher-class properties. These properties attract middle-class tenants with a mix of white-collar and blue-collar workers, so the rents are lower than class A.

Many investors see class B properties as an ideal target for value-add opportunities, where they renovate the buildings and lower expenses to make the property more valuable. This strategy allows for cash flow during ownership, and a large profit on sale. Although they are riskier than class A properties, they have become very desirable lately due to the number of investors interested in value-add projects. Lenders provide average terms on these properties with less leverage and higher rates than loans on class A properties.

Class C

As you may have guessed, class C properties are older, have more maintenance issues, and are located in less desirable areas of town. They are typically 25-40 years old with dated interiors and exteriors, possibly with the original appliances that were installed when the property was built. The renters are blue-collar with low to moderate income, and they are often renters for life. The rents are therefore lower than market rate.

For investors, these properties can generate the most cash flow, but they will have little appreciation. A class C property in a class B area can be a great opportunity to fix up and turn into a class B property to command higher rents and better tenants. In general though, class C properties will have higher vacancies and turnover than class B and A properties. The higher risk in these properties makes larger regional and national lenders avoid financing them, so often local banks finance these deals. These loans will have higher rates, shorter terms, and low loan-to-value, at around 65%.

Class D

Class D properties are the worst in the market. They are over 40 years old with no amenities, high vacancy, low rents, and many maintenance issues. The tenants are low income and often government-subsidized. These properties are in poorer areas of town that often have high crime rates. Given all these factors, these properties are for experienced investors only, and even those investors should have an abundance of caution.

Neighborhood Classes

Neighborhood classes follow a similar pattern to property classes with class A as the better areas and class D as the worse areas. Generally properties have the same class as the area they are in, so a class A property would be in a class A area. However, it is possible to find properties with different classes in the same area, which can lead to opportunities and pitfalls. For instance, a class B property in a class A area has lower risk and better upside to renovate and improve value. A class B property in a class C area would generally have more risk and little upside potential.

Class A

Class A areas are the most affluent sections of a market, often with the newest buildings, best schools, and in-demand restaurants. Real estate in these areas is usually the most expensive to purchase, but given the demand from high-quality tenants, it can be the least risky area to invest. 

Class B

One step below class A are class B areas, which are safe, middle-class neighborhoods with decent restaurants, retail, and schools. The buildings and infrastructure are older than in a class A area. The tenants in these areas will be a mix of blue-collar and white-collar workers.

Class C

Class C areas are lower-income with older buildings. You can often find payday lenders, pawn shops, and similar businesses in these areas, and crime will be higher. The tenant base will be people with low-wage jobs or government subsidies.

Class D

A class D area is often referred to as a "war zone" in which you would not want to travel as there is high crime in this area. Many buildings may be run-down, vacant, or boarded-up. As with class D properties, it is very risky to invest in a class D area.

Summary

Knowing these different classes of properties and neighborhoods will help you to choose an investment that meets your investing goals and risk profile. Class A properties and areas generally provide the least risk, but are more expensive and thus have lower returns. If you are looking for steady, reliable cash flow, you may want to invest in those properties. As you go down to B and C properties and areas, the risk increases, but the returns usually increase as well to account for that risk. These investments can be good for investors looking to grow their capital. 

If you didn't know which property classes you wanted to invest in before, hopefully now you can make that decision.