Multifamily properties are classified into 4 classes based on the property valuation and the associated returns and risks. Typically, the 4 distinct classes of multifamily assets are Classes A, B, C, and D. The grading provides investors with a good idea of the appreciation potential of the property and its rentability performance.
As an investor, knowledge of the distinguishing factors between each class will help you evaluate which asset class will best align with your goals. In this blog, we will dive deep into what are the deciding factors when grading multifamily properties and how can you decide on your preferred investment category based on your risk tolerance and target returns.
Class A Multifamily Property
Less than 10-year-old properties that have the best quality with modern features and high-end finishes are graded as Class A multifamily properties. Located in a luxury market, they have the highest quality construction and form the most expensive category. Class A properties typically charge higher rental prices and draw affluent renters because of their high standards. Class A properties are frequently preferred by investors looking for lower risk, predictable cash flow, and fewer maintenance requirements.
Class A properties have the lowest cap rates, which means even though they are risk-free investments, the returns provided with this category of asset are generally lower. As Class A properties are the most high-priced in the market, investors must perform adequate due diligence to ensure the returns provided with the property are able to balance the high acquisition cost. Further, because Class A properties already have the highest rent in the market, they usually have a low margin for further growth, which is an essential factor to consider during underwriting. During economic downturns, Class A properties tend to have the highest vacancy rate, as people look for more affordable housing options.
Class A multifamily investments are best for investors with low-risk tolerance. However, with high acquisition costs, they yield less cash flow, thus, becoming a barrier for most of the investors entering the market.
Class B Multifamily Property
Generally built within the last 15 to 30 years, they offer good quality construction and serve middle-income tenants. In terms of amenities and tenant profile, they occupy the middle spectrum, which is a little less than Class A, but better than other property grades. Located in smaller markets, they cater to budget-conscious tenants. They offer excellent value-add opportunities, thus enabling increased rental income, resulting in higher returns. As it caters to a broad category of population looking for affordable housing, this category of property remains relatively resilient to economic downturns. Additionally, they are more affordable investments than Class A properties, making it easier to finance and start an investment journey.
For a successful and rewarding Class B investment, investors should focus on a “hot” market with excellent demographics, job growth, and favorable neighborhoods. As the cost of acquisition of Class B properties is considerably less than Class A properties, with little expenditure on renovation of these apartments, they offer better opportunities for higher returns. Their cap rates are higher than Class A properties, but lower than Class C properties, which makes them a balanced bet in terms of moderate risk and high returns.
This affordable asset class offers good value-add opportunities that can provide high cash flow to the investors. As this class remains one of the most sought-after investments, they offer high competition. However, with adequate market assessment and strategic value-add upgrades, the risks involved can be mitigated.
Class C Multifamily Properties
Built within the last 30 to 50 years, this class of property is located in less desirable neighborhoods with fewer amenities. This asset class is in need of considerable renovation and upgrades. They attract lower-income tenants and offer less rental income than Class A and Class B properties. However, if they are strategically acquired and skillfully upgraded, they have the highest potential for growth and property appreciation. Acquiring these at low rates and then spending on renovation and upgrades per the tenant’s requirements can be a smart strategy for investors to generate high returns. Their cap rates are higher than Class B grade, as they have a considerable risk factor involved in terms of increased maintenance requirements, high vacancy, and less desirable neighborhoods. However, in parallel, they also have immense potential for high returns.
To ensure Class C projects are a success, investors should proceed cautiously with a smart investment strategy. With intensive management and strategized value-add renovations, these investments have the potential to offer the highest cash flow out of all the other categories. A smart tip while investing in Class C properties is to look for these properties in the Class B submarket where there is potential for growth with some upgrades.
As they are an affordable asset class, they appeal to most investors. However, they require significant maintenance and renovation to force appreciation and benefit from high returns. It is smart to invest in these types of properties with an experienced syndicator who can tactfully force appreciation through operational efficiencies, renovations, and rebranding, while the investor enjoys high returns without doing any heavy lifting.
Class D Multifamily Properties
This is the least preferred class and the assets belonging to this grade are at least 50 years old. These properties are typically located in economically distressed areas with limited demand and fewer amenities. With low market appeal and poor maintenance, they are the most functionally obsolete class. Despite being the cheapest acquisition amongst other classes, they have the highest risk, as rental income is low and tenant defaulters are high. With high vacancy rates, intensive management requirements, and unfavorable locality, this class is the least preferred investment.
While the cheap price might attract investors to this class; however, it is important to tread carefully when investing in this asset type, as they involve the highest risk with below-average rental rates and high tenant defaulters.
Classification of multifamily assets and weighing the pros and cons associated with each of them are valuable information for both investors and lenders. The classification helps evaluate the long-term potential of the investment. Before investing in any asset, the investors should first define their investment goals. Based on their risk tolerance, hold period, expected returns, and management resources, it will be easier to narrow down the asset class that aligns with their investment goals.
While Class A has high stability, they are also extremely expensive to finance, thus, may become an entry barrier for investors. Class B and Class C offer more potential for appreciation and are comparatively cheaper to acquire. However, generating high returns from these asset types requires adequate management.
To summarize, Class B and C with their higher cap rates provide better returns than Class A properties; however, this comes at the cost of increased risk. Investing alongside an experience syndicator can help investors avoid the hassles of operational and day-to-day management activities while enjoying higher cash flow from these classes of assets.