Class A vs Class C Buildings: Which Really Makes More Money?

Alright, so we all have that one buddy who swears up and down that boarding houses are cash cows. And then you see the sophisticated owners with Class A properties who appear to be profiting more than you.

How do the numbers actually add up?

You’re in real estate because you want to control your own destiny, and real estate returns do change dramatically from one operator to another. That’s the beauty of real estate – run a tighter ship, and you can rake in more dough.

Keeping in mind the ability of the investor to affect the return, what overall return should you be directing your focus to? Here are some factors to consider:

Class A Properties: Luxurious and Premium

Class A properties are synonymous with luxury, boasting top-tier amenities, prime locations, and high-quality construction. These properties cater to affluent tenants who are willing to pay a premium for superior living or working environments. Common examples include luxury apartments, high-end office buildings, and upscale retail centers.

Profit Potential of Class A Properties:

  1. Stability and Appreciation: Class A properties tend to exhibit more stable cash flows and higher appreciation potential over the long term. Their prime locations and premium features attract affluent tenants, reducing vacancy risks and enhancing property values.
  2. Stronger Rental Income: The premium nature of Class A properties allows landlords to command higher rental rates, resulting in substantial rental income. Additionally, tenants in Class A properties are often more financially stable, reducing the likelihood of rent defaults.
  3. Value Preservation: Class A properties are typically constructed using high-quality materials and are newer overall, leading to better durability and lower maintenance costs over time. This contributes to preserving the property’s value and mitigating depreciation risks.
  4. Attractive Financing Options: Lenders may offer more favorable financing terms for Class A properties due to their perceived lower-risk profile. This can translate into lower interest rates, higher loan-to-value ratios, and reduced financing costs, further enhancing overall returns.
  5. Tax Profile: Class A properties are typically newer, and may provide a higher cost segregation allotment than an older property. If you have energy efficiency items (more likely in Class A), these can qualify for Energy Efficiency Tax Credits and offset the building income so your after tax return is higher.

The Downside of Class A Properties:

  1. Sale Returns: With newer, Class A properties, more of the overall return is realized in the end sale of the property. This means it’s vital to exercise a sale in an UP cycle, making timing critical – which can forfeit some of your return if missed.
  2. Exposed to Recession: Newer Class A product is more exposed in an economic downturn. If tenants face job losses, they may downgrade to a Class B property, leaving you more exposed to the pressures of the overall market. Rents may need to decrease to counteract lower occupancy in a recession.

Class B Properties: Mid-Tier

Class B properties are the meat between the hot dog bun. For many investors, this mid-type is the perfect place to be. Class B properties are usually in good areas but not high-tier locations, are 10-40 years old, and have lower rents usually associated with dated properties.

You can take a Class C and make it a B, or take a B and make it a B+. Usually, it’s hard to make a B into an A because of factors you can’t change, like location. Many of the same factors for A and C will apply to Class B properties, so we’ll move on to cover Class C.

Class C Properties: Affordable and High-Yield

Class C properties represent more modest and affordable options, often located in secondary or tertiary markets or low-tier school districts. These properties may have older, lower-quality construction and fewer amenities compared to their Class A counterparts. Class C properties typically cater to middle- or lower-income tenants seeking more budget-friendly housing.

Profit Potential of Class C Properties:

  1. Cash Cow: Class C properties often offer higher cash flow yields compared to Class A properties. While rental rates may be lower, the initial investment is also lower, resulting in stronger cash-on-cash returns for investors.
  2. Value-Add Opportunities: Class C properties may present value-add opportunities through renovations, repositioning, or operational improvements. By upgrading amenities, enhancing curb appeal, or implementing cost-saving measures, investors can increase rental income and property value over time.
  3. Less Competitive Acquisition: Class C properties may face less competition during acquisition, allowing investors to negotiate more favorable purchase prices. Additionally, lower barriers to entry in Class C markets may provide opportunities for investors to establish a foothold in emerging or overlooked areas.
  4. Resilience in Economic Downturns: During economic downturns, Class C properties may exhibit greater resilience as demand for affordable housing or commercial space remains relatively stable. This can provide a buffer against market volatility and help to maintain consistent cash flow.

The Downside to Class C Properties

  1. Bummer, Man: Your tenants may not be the premier, easy-to-deal-with type, choosing to sit on the porch smoking instead of working. Okay, so you decide you don’t mind, but some of your other tenants may. And then, you have issues. As far as the not working part, sometimes that can make it hard to pay your rent. What a downer, better light up another to pick us back up.
  2. Cash-Eating Machine: Your maintenance person practically lives (or does live!) at the building because when stuff is this old, it breaks – a lot. Then your maintenance person want to be paid a lot, and you end up with less cash.
  3. Less Appreciation: Class C will appreciate less over time, usually only lifting in value following inflation and the overall market.

Conclusion:

There is clear data that shows the difference in CAP rates for the different classes of multifamily properties. However, looking at CAP rate alone doesn’t tell the whole story – appreciation, cash flow, and tax benefits are the trifecta.

The end answer to what type of property is best comes down to your personal choice – which component of real estate do you most need right now? Let that guide your answer and you’ll be well on your way to a profitable return.

Ready to find your next investment? Check out our recent listings here.

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