Investment Property, A vs. B & C Class Assets

When entering the world of Buy and Hold Real Estate Investing, there are generally more questions than answers. There is a lot to consider regarding the best type of investment for your specific purposes. One of those being, what type of property to acquire, and additionally, what type of returns to expect and how much of your time and effort the different options will require. In this edition, we’ll discuss the difference between A, B, and C class properties, how to calculate CAP Rate vs. Cash flow, and what to expect from the different types of properties.

First, let’s talk about how to determine the class of a property. The class of a property is somewhat subjective, and is established by a number of factors. The evaluation consists of the age of the property, location/neighborhood, demographic and income level of tenants, and overall condition.

A Class- Typically newer properties, built in the last 15 years. Higher tenant income, with little to no deferred maintenance, and low vacancy and turnover rates. Generally these properties sell at a lower CAP Rate, but come with a much lower risk factor.

B Class- Somewhat older properties, generally built between 15 and 30 years prior. Lower tenant income demographic than A class, but still usually stable investments. Tenant turnover and deferred maintenance will be a bit higher here, and less desirable neighborhoods.

C Class- Usually properties built over 30 years ago. Low tenant income puts these properties in a demographic that will result in high tenant turnover, evictions, and deferred maintenance on a consistent basis. Typically found in low income neighborhoods. C class properties sell at double digit CAP rates, and can be very lucrative, but require a lot of hands on management in order for them to perform at that level.

D Class- Don’t do this unless you really know what you’re getting into! These are very old buildings in dangerous areas. Very difficult to manage and create returns.

So what is CAP or Capitalization rate? We use CAP rate to describe the rate of return on income properties in a universally understood manor. Calculating CAP rate is done by dividing your NOI, or Net Operating Income, by the Purchase Price of the Property. For NOI, simply subtract your Operating expenses (ie: taxes, management fees, etc.) from yearly rental income. For example, if the rental analysis projects $1000/month, your annual gross income is $12,000. Subtract taxes, let’s say $800, and management fees at the standard 10%, $1200, and you have your NOI of $10,000. Now divide by the Purchase Price, say $150,000, to get your CAP rate: 6.6. This example simulates an A Class single family home in the Phoenix Metro area. The CAP rate, is lower, but that also indicates a very stable investment with minimal risk. Let’s look at an example of a C Class Multi-Family property. Say you have 12 units that rent at $550/month, your annual gross rental income then looks like $79,200, then subtract expenses for NOI of $72,156. Divided by the purchase price of say $500,000, gives you a CAP rate of 14.4. So, you can see how, at first glance, C Class may look like the better investment. We’ll come back and take a deeper look at this in a minute.

First, let’s establish, that CAP rate is not the same as Cash Flow or Cash on Cash Return. If you’re looking at using your investment properties to replace your monthly salary, or income, you’ll need to determine your Cash Flow as well. In order to estimate your monthly passive income, simply take your NOI from above and subtract your debt servicing expense, or Mortgage Payment, only this time we’re calculating on a monthly basis instead of annually. I’ll use the Single family example from above. So, if I were to finance the $150,000 investment property with a conventional loan, we’re looking at 80% LTV (Loan to Value) and an APR of approximately 4.5% by the current Fed. This would make my mortgage payment $608.02. Subtract that from my monthly NOI, and I’m cash flowing $225.98/month in passive income. (If there is an HOA, you’ll need to factor that cost in as well, this can kill your CAP rate, so make sure you watch for these fees).

Ok, now that the math is out of the way, we’ll revisit the pros and cons of each property type. As I mentioned before, a lower CAP rate indicates stability of the asset performance, but also a lower return. You’ll find this in A and B+ class properties. These are lower risk investments with high appreciation potential. They are great for newer investors, conducive to professional management, and therefore completely passive income. With this type of property, you’ll find very little to no time is required of the investor. Generally more of these properties are needed to create a bulk of cash flow as income replacement. B class property can also produce this kind of result, but they’re older properties, so always assume more maintenance cost. These can be Duplexes, 4-Plexes, 8-Plexes, or older Single Family homes with generally higher CAP rates. You’ll find higher tenant turn over than A Class, but for the most part, also very stable investments. In C Class property, all units need to be occupied and paying rent for the asset to perform at the high CAP rate. Usually professional management companies don’t work with properties like this because they require door knocking to collect rent on time, constant supervision to make sure none of the tenants are harming the property, and considerably more money on maintenance and upkeep. This type of property is not for the faint of heart, requires hands on aggressive management, is probably not for out of state investors, and I would only recommend to seasoned vets. That being said, there is a lot of money to be made here if handled properly.

The type of investment that is right for each individual investor will depend on the WHY. What’s your reason for investing in Real Estate? Do you need to be hands off? Or do you intend to make this your full time job for the next few years? Ask yourself these questions, and build a team of professionals to give you the tools and expertise required to obtain your investments. There is no right answer, everyone’s Real Estate business is unique, and changes with the market. Good luck, and happy investing!

For more on the Phoenix Real Estate Investment market, please visit http://gentrypm.com/population-growth-and-how-to-profit-from-it/