Even under pandemic-dampened conditions, over $280 Billion of commercial property changed hands in 2020. That figure represents thousands of assets that spent time on the selling block.
With so many opportunities on offer, how can you quickly narrow down the list to research those that best fit your investment profile?
One way investors and brokers wrangle the chaos is by categorizing buildings by property class.
Property class is a stratification of real estate that places buildings into three groups—A, B, or C, with “A” being considered the most valuable—based on criteria like building condition, location, and quality of the tenants that occupy them.
Once you understand how property classes work, you can quickly filter out investment opportunities that don’t match your goals—leaving you more time to research the ones that do.
In practice, the classification of real estate is subjective. Anyone can label a property as Class A, B, or C as they see fit, and there are no organizations to certify that choice.
That said, property classes are still a useful guideline since most CRE pros will use generally agreed-upon factors to decide how each building should be classified.
The age, amenities, and upkeep of a building have a huge influence on its property class.
The age of a property is one of the most important factors for classification. No matter how great it’s been managed, a 30-year-old office building will not likely be a Class A property.
The building’s amenities also play a role. Two properties might be of similar age, but if one has an executive kitchen, gym, and secure parking, it will more likely be classified as A.
When a building has a significant amount of deferred maintenance—necessary repairs that are put on hold—it will likely be considered a lower class than properties that are otherwise similar. So physical upkeep helps determine property class as well.
The location of a property affects its classification in two ways.
First, the characteristics of the surrounding neighborhood help determine how a building is classed. Those factors may include:
Second, property class is contextually based on the other buildings around it. A building might be called Class A because it’s the best property available in one location, but in another location, where better buildings exist, it would be a B.
Quality tenants with good credit mean safe and steady income. On the flip side, tenants with less-established credit represent an investment with greater risk due to non-payment or eviction. For that reason, tenant quality correlates directly with property class.
In addition to the actual tenant, the lease they hold can help influence property class assignment. If the tenants are all in long-term, triple-net leases with regular rent increases baked in, the investment is more desirable and will nudge the property class higher.
It’s tempting to say that Class A is “better” than Class B or C—A buildings are nicer, in better locations, and have great tenants. But each property class offers a different balance of growth potential, risk, and revenue to fit different investment strategies.
Class A properties are the premium assets in their market and attract the best tenants. As such, they offer income stability and liquidity but provide lower cash flow and are less accessible for many investors.
Typical characteristics of a Class A building:
With high credit tenants in place and all necessary maintenance up to date, a Class A property is less likely to suffer from unexpected loss of income. That’s great if you’re looking for a buy-and-hold investment with passive income.
You can also expect a Class A asset to be more liquid than other options. That’s because Class A is always in demand, so it’s easy to sell quickly if you need to.
All that upside comes at a cost, though. Class A buildings are the highest priced in their market. They’re also among the largest since top-notch tenants often need larger spaces. That places these investments out of reach for all but the largest investors.
The high price of a Class-A property typically requires higher debt service, so cash flow is lower even with higher rents. Plus, Class-As are already at the top of the market, so there’s not much opportunity to add new value for income growth.
Investment in a Class-B property comes with a little more risk in both tenants and potential repair costs, but they also offer income-increasing value-add opportunities and are great for BRRRR (buy, rehab, rent, refinance, repeat) investors.
Typical characteristics of Class-B properties:
Class B buildings are often former Class-As that were downgraded over time. This presents a great opportunity to investors with a tolerance for rehab. Those buyers can get a building at a value, update it, and attract higher rent-paying tenants. Sometimes, just placing a great property manager is enough to boost rents.
With higher-paying tenants comes a higher valuation and instant equity. Now the investor can cash out through a sale or refinance or simply hold and enjoy steady cash flow.
There is, however, more risk when investing in Class-B buildings. Unexpected repair costs and potential tenant issues are more common than with Class-A properties.
Class-C properties suffer from more inherent risk and less long-term appreciation but can provide substantial short-term cash-on-cash returns.
Typical characteristics of Class-C properties:
Class-C properties are known for their high cash-on-cash return. That’s because it takes less capital to buy a low-priced C building, so the comparative income vs. investment is higher. For the same reason, cap rates on these lower-priced buildings are higher than A and B-class properties.
However, Class-C properties are usually located in less desirable locations that don’t appreciate quickly (unless you’re betting that a neighborhood will flip). Plus, high holding costs due to maintenance issues and tenant turnover add up over time. All of this makes Class-C investments less profitable over the long term.
When faced with a never-ending flow of new potential CRE investments to review, property class is a useful way to sift through them. But it is only a top-level filter and should never take the place of thorough due diligence.
Instead, start your search using property class as a first-level review. Then pluck the opportunities that might fit your goals and complete a deeper dive into those prospects.