Commercial Real Estate Assets are ‘graded’ using letters A-D.
How does this work?
Like buying a house, you would normally set out with a vision in mind in what you are looking for. Like a 4BR/3BA, 2 Car Garage, etc. In commercial real estate, we are looking at size, location, project type, and property class (amongst many other things).
Property Classes range from letters A to D. A, being the ‘best of the best’ and, D being at the bottom of the spectrum.
A Class Properties:
A Class properties are the best assets in the best locations that you can think of. These properties are usually newer developments in primary markets (like downtown), and offer the best amenities in a particular market, such as; pool, gym, dog park, lounge, etc.
B Class Properties:
B Class properties are still nice, but may be a bit older than Class A properties. B properties tend to have some little or no deferred maintenance, and may still offer some amenities. As you can imagine, B class properties would not demand as high of rent as Class A, but are still highly desirable.
C Class Properties:
C Class Properties tend to be 20+ years old and are located in neighborhoods that are still ‘developing’. These property types usually have deferred maintenance like older roofs, peeling paint, and have ‘classic’ interior finishes like laminate floors, and wood paneling.
D Class Properties:
Moving down the spectrum, is D class properties. Just like a report card, a ‘D’, is nearly failing. As you can imagine, these properties are similar in a sense that they are older, run down, poorly managed, usually have unstable tenants, and are located in neighborhoods that are pretty, “rough around the edges”.
How are properties classed?
Property are classed by several factors, such as; location, age, and condition. On another note, properties can be ‘repositioned’ to move up in class. For example, if you have a ‘C’ property in a neighborhood that is changing in a positive direction, and you were to gut it and finish it like a new property, you could turn the property into a ‘B’ property that would now be more desirable and can demand higher rents.
You know the saying, “Location, Location, Location”. Well, its true, location is one of the biggest factors when it comes to grading real estate assets. If we are looking at the same Class A asset in a primary market as we did in a secondary market, chances are the downtown location will demand a higher premium, therefore will be of greater value.
Age is an important factor, but not as important as its Location, and Condition. Here’s why; There is a limited amount of buildable land available in primary markets. So if you have a ‘historic’ building that’s over 100 years old but sits on the best corner in town, depending on its condition, it could be one of the most valuable assets nearby, because of its location! On the other hand, if the property is in a secondary or tertiary market, the historic building could appear as a C Class property.
One of the most important factors in determining the asset class, is the properties current condition. How much deferred maintenance is there to be done? (Ie. How are the roofs? How is the exterior condition? Is there paint peeling?) All of these questions will enable you to determine the property’s condition.
Comparing Asset Classes:
There are advantages and disadvantages to each asset type. With the right strategy and business plan, each can have great success.
A Class properties are the most desirable properties since they are usually in the best markets, have no deferred maintenance, and will be most desired by a future investor. These property types typically have more creditworthy tenants which means less evictions or lower delinquency rates. The potential disadvantage of Class A Assets is that when they become a few years old, and newer construction happens nearby, these tenants could consider moving into the newer property as they can most likely afford it.
B Class Properties, compared to A Class Properties, are still nice buildings in great neighborhoods but may have older finishes like; black/white appliances, light wood styled cabinets, etc. Because of these older finishes, these B Class properties offer an opportunity to update some finishes to potentially compete with Class A properties.
C Class Properties, compared to B Class Properties, might be located in lower income neighborhoods, and will likely have quite a bit of deferred maintenance. C class properties demand tenants with lower income and although they can produce high cash on cash return, they tend to have less stable cash flows than higher graded assets.
D Class Properties, compared to C Class properties, are usually found in the worst neighborhoods with higher crime rates, and with the immediate population in poverty level. These assets sometimes allow Section 8 tenants (Government Rental Assistance), and can be very run down and in extremely poor conditions. These assets can be extremely ‘cheap’ compared to other properties, and can usually be purchased for far less than replacement cost.
There is no better or worse investment type. With the right strategy, and business plan, investors can find success within each asset type. The overall ideal asset depends really on the investors goals. At Dovetail, we are primarily focused on Class B assets as they demand quality tenants and have little or no deferred maintenance. Class B Assets will also be a favorable property type years down the road as the property will eventually need to be updated and would present a “value-add” opportunity.
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