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There are many different types of multifamily property investments available to the passive investor. That’s why it’s best to understand the different types of classifications in order to make an investment in the appropriate type of property that meets your particular needs, as well one that suits your specific strategy and investment goals.
The different classifications are provided based on a variety of factors including the property’s age, location, rental income, management and more. Each different classification represents a different type of risk as well as the potential return on your investment. We’ll look at the three primary multifamily classifications and cover their benefits as well as their challenges.
Class A Properties: New Construction, Often in the Most Affluent Neighborhoods
Class A properties are often called luxury properties, and for good reason. They’re the “cream of the crop,” and they’re either brand new or less than 10-years old. The classification is also given to properties that have undergone extensive renovation during the past 10 years.
These multifamily properties receive higher rents than Class B or C properties. According to Real Page, a real estate analytics company, Class A multifamily properties averaged $1,660 per month in the 100 largest U.S. metro areas. That amount is almost double than the average Class C property rental rates.
Why such a high disparity between Class A and Class C rental rates? Their location plays a significant role. The Class A properties are often located in the city’s most affluent neighborhoods, and feature expensive home prices in the immediate area. In addition to location, Class A multifamily properties feature high-end amenities, including custom interior options, tennis courts, a health and wellness center or clubhouse, swimming pools and more.
Another key to a Class A property is that they have top quality management in place. And there is a very low likelihood of the property requiring any type of major renovation in the near future. Thanks to their location and amenities, Class A multifamily properties attract the best tenants - ones who have professional jobs and superior credit scores.
These properties also tend to increase in value at a much faster rate than Class B and C properties. Rather than invest in Class A properties, many investors prefer to develop these type of luxury properties as the potential for profitability is much higher. On the other hand, investing in a Class A multifamily property means that there is already a steady cash flow in place. And since the tenants are stable with professional jobs, the likelihood of tenant turnover is low.
This is in direct contrast to developing a Class A property from scratch. Developing is a complex, long-term process that could face many delays, permit and environmental hurdles and cost overruns. Plus, there could be a long lease up after construction is completed. While it may be more profitable to develop this type of property, the risks to the investors are higher as well.
Class B Properties: 10-25 Year-Old Buildings in Safe, Middle-Class Neighborhoods
Most of the Class B properties are located close to Class A properties and neighborhoods, but their age is older. These properties are enjoying growth in value, but their rents are about 15%-30% lower than Class A properties, coming in at an average of $1,152 per month.
Even though Class B properties are significantly older than their Class A counterparts, they usually don’t require expensive foundation or structural renovations or repairs. Their interiors are often dated and would require updating in order to justify rent increases and attract a higher-end tenant, but usually won’t need to have expensive repairs like heating and cooling or mechanical systems.
A lot of Class B properties feature some desired amenities, like swimming pools and fitness facilities, but due to the age of the property those amenities would require updating as well. Even though the property shows well with pleasing landscaping, it won’t come close to matching the attractive curb appeal and luxury appearance of a Class A property without repositioning.
So why invest in a Class B multifamily property? Investors and their sponsor will have an excellent opportunity to renovate the building and turn it into a nicer asset, and increase rents to be just below a neighboring Class A building. This would result in an increase in income, and would help to boost its value for a possible future sale.
Renovating the property may require a substantial infusion of capital, so the sponsor would have to be done in order to determine if the investment in upgrades and improvements is worth the time and money involved. Adding amenities that would justify rent increases include updating a fitness center, providing security features like cameras and keyless entries, offering custom interior features inside the units and other improvements such as yoga rooms, bike storage, etc. Some upgrades can end up adding additional fees and increased rents, like laundry facilities or preferred parking spaces, for example.
Less costly building improvements would focus on cosmetic changes that would update the building and include new signage, painting, landscaping upgrades and other similar changes. Another approach is to consider changing the existing property management company. Different property management companies often have their own proven innovative policies that can streamline efficiency, and because they have competitive fees you might find one that offers significant savings.
Regardless of the approach you take in repositioning and renovating the Class B property, make sure that the final product fits with the neighborhood where it’s located. In some areas, the ability to increase rents will be difficult due to factors like crime rates or tenant demographics in the surrounding communities.
Class C Properties: 25-45 Year-Old Buildings in Low to Moderate Income Neighborhoods
While the classification states 25-45 year-old buildings, they’re generally over 35 years old with minimal amenities, dated exteriors and often have deferred maintenance issues. The other factor is their location, as they’re often found in low- to moderate-income neighborhoods. While Class C rents increased above the rate of inflation, rents for these properties averaged $1,003.
Class C properties bear several issues, including the fact that they often have their original appliances, light fixtures and wiring. Due to their age, the sponsor will need to inject capital to the building’s foundation and structure, as well as the mechanical systems. Investors often purchase Class C properties with the intention of replacing HVAC equipment, electrical wiring and plumbing.
Some of the neighborhoods and adjoining areas where Class C properties are located can be problematic in attracting tenants. Often there is a higher crime rate, schools are not the top performers in the city, and the area lacks amenities like restaurants, entertainment venues and other neighborhood draws. Some of these properties are fortunate to be in areas that are undergoing re-gentrification, but unless you have experience and knowledge in Class C properties, or work with a sponsor who does, it’s best to invest your money elsewhere.
There are many investors that seek out Class C multifamily properties, because they see that there can be an amazing potential in renovating, upgrading and repositioning them. It takes more than money to reap the rewards, however. It also takes knowledge and a strong indication that the area surrounding the Class C property is on the upswing. They can sometimes purchase these properties at a substantial discount, and with the proper repairs and upgrades, they can realize a larger monthly profit margin and hopefully sell for a capital gain down the road.
Class D Properties: 45+ Year and Older Buildings, Often in High Crime Areas
The lowest classification for multifamily properties is Class D buildings. They’re often over 40 years ols, have little or no amenities, and often have a high vacancy rate due to their location in high crime, low-income areas. Due to their age and low cash flow thanks to high vacancies, these buildings are often in disrepair and require extensive work and renovation to bring them to a level where tenants would want to live in them.
Due to their location in high crime areas, it’s difficult at best to consider upgrading these properties and being able to generate a positive monthly cash flow. These are the properties that only very experienced investors with high tolerance for risk should invest in. It may take years to see an upswing in the area, if one ever occurs at all without municipal intervention.
Summary
Each multifamily classification presents unique opportunities for investors to see income and appreciation. Which one to invest in depends on your particular investment goals and strategies, as well as the recommendation of your investment sponsor if you’re a passive investor. The best opportunity is investing in properties that are located within a higher Class neighborhood, such as a Class B property in a Class A neighborhood, or a Class C property in a Class B neighborhood. Renovating the property can bring both increased monthly income with higher rents and a potential for asset appreciation.
About the author
Ellie is the founder of Blue Lake Capital, a real estate company that specializes is multifamily investing throughout the United States. She is also the host of a weekly podcast called "That REllie Happened?! Unbelievable Real Estate Stories with Ellie", a podcast that brings the true stories behind the deals, from the most successful real estate investors around the globe. Ellie started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.
You can read more about Blue Lake Capital at www.bluelake-capital.com and learn more about Ellie at www.ellieperlman.com