For hundreds of years, investing in commercial real estate has been a major builder of generational wealth. It has enabled investors to achieve regular cash flows, strong asset appreciation, as well as enjoy significant tax benefits.
Investment into multi-family units as an asset class remains as one of the most popular forms of REPE investments as it is easily understood by and accessible for most investors. However, “multi-family assets” can be said to be an umbrella term for various types of residential rentals, and it’s important for any investor to distinguish between the different types and classes of such properties to determine which property type best fits its investment goals
Typically, multi-family units can be separated into four distinct categories, known as Class A, Class B, Class C and Class D apartments. This categorization or grading helps with the evaluation of such properties in terms of potential for rentability and capital appreciation.
The designation for these classes involves reviewing several important physical and financial characteristics and is primarily based on factors such as:
- location of the property and quality of the neighbourhood;
- age and condition;
- facilities or amenities available either within the building or nearby;
- affordability of potential occupiers;
- rental income being produced by the property;
- potential for capital appreciation;
- quality of property management.
Of course, everything is relative and, so, when considering grading a property this needs to be evaluated in the context of other similarly graded properties in the general vicinity and not be compared with other properties in a different geographic location or even town or city!
Just as with a capital stack where the priorities of equity and debt in a REPE transaction are placed in order of priority, grading multi-family assets can be seen in the same way.
Clearly, Grade A multi-family properties will occupy the uppermost reaches, with Grade D at the bottom.
So, let’s have a closer look at the various gradings:
Class A multi-family property
Class A properties represent the newest and best-maintained properties at the most expensive end of the property spectrum within a local market, and with the following characteristics:
- location of the property and quality of the neighbourhood: in the most desirable parts of a town or city, with little evident crime;
- age and condition: built within the past 10 years and still in good repair and condition; generally well-maintained properties;
- facilities or amenities available either within the building or nearby: good support and neighbourhood facilities such as, maybe, an in-house gym, concierge services and close to local convenience shopping and services;
- affordability of potential occupiers: professional or higher-income earners are the majority of tenants, many of who stay longer than the “average” tenant;
- rental income being produced by the property: strong rental rates and low vacancy rates as units are always in demand;
- potential for capital appreciation: likely to continue into the future;
- property management: regular maintenance and good quality support services.
Class A apartments will also have the highest “price per unit” or per m2 and market cap rates are generally lower than any other multi-family real estate asset classes. This may make the entry cost of investment into Grade A multi-family units seem prohibitive. However, with more and more opportunities for syndicated passive investment in REPE transactions, this means a greater number of investors can share in the wealth building. For a closer look at a Class A asset click here to see CPI Capital portfolio
Class B multi-family property
Class B properties represent relatively well-built and maintained properties at the higher but not top end of the property spectrum within a local market and have the following characteristics:
- location of the property and quality of the neighbourhood: in good quality neighbourhoods close to schools and shopping areas, and often occupied by middle-income families;
- age and condition: usually over 10 years old but generally well-maintained properties and in reasonable condition and repair;
- facilities or amenities available either within the building or nearby: convenient but not prime locations, close to a selection of amenities and facilities;
- affordability of potential occupiers: middle to upper income-income earners with demand from larger demographic of the population;
- rental income being produced by the property: slightly above market average, steady rental rates and lowish vacancy rates, although with some tenant turnover;
- potential for capital appreciation: reasonable chance for appreciation as broader based demand for such units;
- property management: regular maintenance, although some repairs may still be needed, they may not be major; acceptable quality support services.
Class B multi-family apartments will remain in demand and are generally more affordable than Grade A units, with higher market cap rates. The entry cost of investment may still be relatively high but, with still attractive returns, a large number of investors are attracted to this type of property. For a closer look at a Class B asset click here to see CPI Capital portfolio
Class C multi-family property
Class C properties are, typically, older homes occupied by middle-income families and, possibly senior citizens who stay in residence for the longer term. Typical characteristics are:
- location of the property and quality of the neighbourhood: older, more mature part of a town or city where some amenities may be lacking and crime higher than the average;
- age and condition: usually over more than 30 years old and often smaller in size and out dated in design compared to newer properties;
- facilities or amenities available either within the building or nearby: limited with occupiers having to seek such amenities in another neighbourhood;
- affordability of potential occupiers: lower to middle-income earners, with properties and neighbourhoods in demand because of their practicality and affordability, rather than the quality or design of the units; indeed, many tenants in class C buildings rent out of necessity;
- rental income being produced by the property: slightly below market average, fairly steady rental rates (maybe with some blips) and lowish vacancy rates, although with some tenant turnover. In fact, Class C assets often provide the best cash flow for investors, partly because a large percentage of the overall population is in need of affordable housing;
- potential for capital appreciation: capital values may or may not increase over time;
- property management: if regular maintenance has been deferred there is the likelihood of major or costly repairs being needed in the not too distant future.
Class C multi-family apartments, with a lower appraised value have a lower barrier to entry for investors with reduced liquidity.
Investing in class C properties can be a good strategy for diversifying an investor’s portfolio and, in fact, many real estate syndicators use a value add strategy to “force the appreciation” of the asset through operational efficiencies, renovations, and rebranding.
Class D multi-family property
Class D properties are older homes which may require significant repairs and/or have code violations. They may be in run-down neighbourhoods lacking a good selection of amenities and have the following characteristics:
- location of the property and quality of the neighbourhood: older suburbs or parts of town which were once prime but have deteriorated; relatively high crime areas; least-expensive homes and buildings in the area;
- age and condition: almost all class D buildings are more than 30-40 years old and in various states of disrepair and neglect;
- affordability of potential occupiers: lowest income level who can just about afford to pay rental as have other debt expenses to deal with;
- rental income being produced by the property: below market average, with high vacancy rates; but high demand and many low income earners cannot afford more;
- potential for capital appreciation: limited opportunity for appreciation unless significant gentrification occurs in the surrounding areas and spills over into the subject area;
- property management: repairs will almost certainly be required, but may not be as expensive or extensive as other property classes as occupants will not expect the highest standards of living.
Class D properties often appear to be interesting to investors due to their low cost and lower financial barrier to entry. Adopting the right investing strategy such as acquiring multiple homes in the same neighbourhood with the intent of gentrifying the area as a whole, can make these assets profitable. In fact, many investors use Class D to get started in property investment.
On the downside, frequent tenant turnover may mean inconsistent revenue with potential tenants preferring not to live in the area due to neighbourhood neglect and/or crime.
At CPI Capital we know that each property class has its own set of risks and rewards. We base our success on understanding the complete range of property types and selecting the most appropriate investments which offer the best returns (both cashflow and capital appreciation) for our investors.
Whilst generally we may not make investments into class C or class D properties, we are aware of, and monitor happenings, in these classes to see if the risk factors can be successfully managed and a suitable C or D property acquired. In any event, an understanding of the language of property classes enables us to work with others in our network about various properties in their target area.
Some syndicators or sponsors find that class C investments offer the highest cash flow and the greatest opportunity to force appreciation and can be top-performing properties for many real estate investors. However, it’s all about risk mitigation and using our experience with class A and B type multi-family properties to the best advantage for our investors.
In short, each REPE multi-family investment has benefits and risks and it’s important, before investing, to comprehensively analyse a project to determine if it fits the desired risk and returns!
CSO, COO, Co-Founder CPI Capital