Summary: Real estate investors often refer to properties (and even to neighborhoods) using a grading system from A to D. A newer investor who is not familiar with these terms may find this classification system to be subjective and often confusing. In this post, I define what we mean by A/B/C/D class properties and explore why Kenji and I prefer buying B/C class properties
If you spend enough time around real estate investors, you’ll inevitably hear them grading properties.
“I only buy A class properties.”
“I focus on investing in B or C class properties.”
And sometimes, you’ll even hear them grading neighborhoods too.
“That’s a C class property in a B neighborhood.”
So what are we talking about? And what properties do you want to own?
In this post, I cover the property and neighborhood grading system real estate investors often use to classify the properties they buy.
I also explain why Kenji and I are such huge fans of B/C class properties. The reasoning might surprise you!
Why the A/B/C/D System?
It’s important to recognize why investors use this system, even though it may be subjective. In our opinion, it isn’t the best system, but it is one of the most widely used. You’ll want to learn it so that you can communicate what you’re looking for to the members of your team, especially your investor agents, and other investors. Clear communication trumps a more preferred system, in this case.
There is another important reason to understand the classification system—it gives you a sense of who will be living in a particular property. This helps you evaluate the risk and return. After that, we’ll move to the reasons why we use the system.
Understanding and using the lingo is helpful, because it facilitates communication about properties and neighborhoods. But again, it’s based more on feeling than it is on science!
Before we get started, I’d like to touch on something important—ethics. We always believe in doing the right thing, and it’s valuable to discuss the reasoning for and ethics behind classifying properties and neighborhoods.
The ethics of classifying properties and neighborhoods
I feel like the grading system, especially regarding neighborhoods, is fraught with underlying ethical considerations. It’s important to be aware of and reflect on the history and current process of classifying tenant bases,especially neighborhoods, when considering where you want to invest.
Many investors don’t know that there’s a history of our government and banks “redlining” specific neighborhoods where Black and minority communities lived. This effectively excludes people in those neighborhoods from being able to obtain mortgages. This disallowed generations of Black and minority families from tapping into the generational wealth that comes from homeownership. The practice of redlining has lasting effects today (and sadly, still occurs in modern times).
Real estate investors sometimes release neighborhood classification maps, and, often, D class neighborhoods are the same neighborhoods that were redlined generations ago. The policy of redlining has had long-lasting negative effects on our country and our people.
I encourage you to be cognizant of the history of racism and classism in this country when investing. You can do this by setting an example for other investors of how to treat your tenants.
Part of what we do is try to improve our properties to make them a safe, clean, well-kept place to live for our tenants. We aim to treat our tenants with respect. We have purchased many properties from “slum lords” who do not care about tenant living conditions or safety. We’ve seen blatant racism among property owners during inspections.
As a real estate investor, this is your chance to be an example of a caring landlord while also running a profitable business. You can be the example for generations to come. Now let’s get to the different types of properties, and then more details for understanding.
Property Characteristics
Most investors seem to include property characteristics and age when grading properties. Again, since there’s no objective way each of these classes are defined, you’ll find different investors including different characteristics and valuing them differently within their grading system.
Some commonly included building characteristics in addition to age include:
- the quality of the building
- affordability
- amenities provided
- tenant income levels
- growth prospects
- expected market appreciation
- livability of the property
- need for upgrades/rehab, location (though some investors separate location out and grade it independently)
- rental income return
As you can see, it’s a lot.
To simplify this for you, here’s a quick rundown of how we define the various property grades.
Class A
Class A properties are quality, newer builds (typically in the last 10-20 years). They have amenities like gyms and a front desk concierge. They also have nicer finishes like granite and quartz countertops and stainless steel appliances.
These properties are often located in downtown areas or nicer single-family neighborhoods. Many people in the area are homeowners, not renters, and attract high-income professionals. If you think back to the types of places you’ve rented, they were probably type A and perhaps B type properties.
It’s hard to cashflow these properties, as they’re often seen as having a higher potential for market appreciation. However, because of this perception, they sell at a higher market rate.
Class B
Class B properties are older builds, often 20-30 years old, with higher-grade rental finishes. They may have wood floors, granite countertops, and luxury vinyl planking and white/black appliances. They don’t often have a lot of amenities. Some larger apartment buildings might have a pool or a front desk. Location-wise, they are often outside of downtown, and perhaps in a neighborhood with more townhouses or other multifamily apartments.
These properties can cashflow decently, and have low vacancy rates. They also have the potential for market appreciation, since they may be fairly close to desirable neighborhoods. Class B properties could also be in the path of progress in terms of city growth. Often people will buy C-class properties, and improve finishes, landscaping and the external appearance to force appreciation and make them more of a B-type property.
Class C
Class C properties are usually those built 30-40 years ago, with pure rental grade finishes. They have cheaper, non-stainless steel appliances, laminate countertops, and rare amenities. Tenants are often working-class. They are usually located in neighborhoods composed of mostly multifamily properties. They may be somewhat worn down.
Class C properties generally cashflow well. Investors can force appreciation by upgrading them to be more type B properties. Management costs could be higher, as could vacancy and turnover.
Class D
Class D properties are older, often run-down and in need of repair. They may be located in areas of high-crime in neighborhoods that are declining. They have the risk of high vacancy and frequent evictions. On paper, class D properties appear to cashflow well, but when you take into account vacancy, it is often not the case.
Classification by property age
Some investors define the class of property purely by age. For example, an A-type property might be built in the last 10 years, a B in the last 20 years, a C in the last 30 years and a D as anything over 40 years old.
This is a pretty narrow definition that doesn’t take into account the unique characteristics of the property. For example, you can imagine a beautifully-finished, brick 1910 multi-family property might sell at a higher multiple than a 2010 rental-grade property.
Therefore, I find a time-based property grading system to be too narrow. I think if you use it in isolation, you’re likely to run into confusion when communicating with your team, as well as potentially misconstrue the projected risk and return of specific properties.
Risk and return by class
One of the most important reasons to understand building class difference is understanding the inherent risks of each class.
Most investors see Type A properties as low risk. Due to the tenant base, there’s a low risk of evictions, for example. Also, there’s the possibility for market appreciation, which attracts a lot of investors.
In comparison, Type D properties are seen as a higher risk and more effort. This is due to the amount of vacancy and evictions. There’s also very little possibility for market appreciation, unless you buy in a neighborhood that becomes “gentrified” down the road.
However, Kenji and I see risk a little differently. As a result, we actually see class B/C properties as the lowest risk.
Why? This is the key to why we prefer B/C multifamily over the other classes.
Why we prefer B/C class properties
Kenji and I invest in assets that cashflow every month. We don’t invest in type A properties for this reason (the owner is hoping for market appreciation!). Type A properties are higher risk in the event of a downturn. If people who live in type A properties lose income for any reason, they downsize their lifestyle and move into Type B/C properties.
We also force these properties to appreciate by improving them and increasing their financial performance. This is easier to do in a B/C property. Many of these properties are neglected by their owners, leaving a lot of room for upgrades and higher rents. When tenants see that both you and your property managers deliver good service, they stay longer. This lowers your turnover and vacancy costs.
Our portfolio is made up of all B/C class properties renting from $700-$1700 a month. We believe this lowers our risk and maximizes our returns over the long term.
Summary
You should familiarize yourself with the A/B/C/D property classification system. Investors and members of your team use it often.
As you build your portfolio, you’ll likely find that you specialize in one or two classes of property types and build up expertise.
Do you know what those classes will be?
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