There are various types of commercial real estate property classes and types. Each of these property classes has different characteristics. Therefore, while commercial real estate investors have a wide variety of investment options in this asset class, it is noteworthy that they should carefully analyze individual property classes in commercial real estate before investing in the one which suits their objectives the most.
So, in this blog, we will discuss the property classes in commercial real estate and crucial details about their location, built conditions, and the risk associated with investing in them.
Read Lilypads’ blog on commercial real estate investments for new investors here.
Property classes in commercial real estate: the basis for their classification
Broadly, there are four different types of commercial real estate assets. These include Office, Industrial, Retail, and Multifamily.
However, there are four property classes in commercial real estate. These include Class A, Class B, Class C, and Class D. Commercial real estate professionals have classified the properties with alphabets to make it easier for interested investors to rate them according to their build quality.
This is important because property classes in commercial real estate indicate different levels of risks and return that an investor can expect.
Therefore, the distinct property classes in commercial real estate enable investors to select properties that align with their risk aversion and return objectives.
Moreover, each property classification is a combination of its physical and geographical characteristics. So, the alphabets A, B, C, and D represent various factors, including:
1. Property age
The age of a commercial real estate asset influences its classification. Class A buildings are typically newer, while Class B and Class properties are relatively older.
Hence, Class A properties comprise a lesser risk of investment than Class B and Class C.
2. Asset condition
Besides The age of the property, its condition is also one of the leading factors of its classification.
Therefore, class properties with high-end renovations and upgrades achieve Class A status. But, the buildings that are weathered and are in need of cosmetic and structural repairs fall into the categories of class B and class C buildings.
3. Location of the property
Class A properties are located in highly desirable urban locations. But, Class B and Class C properties are located in less desirable lower-income neighborhoods.
Therefore, the location of a commercial property can directly affect its investable quality.
Class A properties are equipped with majorly popular amenities like a media room, on-site fitness center, concierge, underground parking, pet daycare, outdoor pool, and so on.
However, class B and class C properties offer fewer or no such amenities to their tenants.
In addition to the aforementioned factors, occupancy also plays an important role in the classification of commercial real estate properties.
Therefore, Class A buildings witness the lowest vacancy levels. On the contrary, Class B and Class C properties have more variable occupancy levels.
6. Quality of tenants
Class A properties typically Attract quality tenants or high-income earning professionals with higher credit scores.
But, Class B and Class C properties usually have less desirable tenants and medium to low-income earning professionals with lower credit ratings.
In addition to these factors, rental income, appreciation, and growth properties of an asset also influence its classification.
The primary property classes in commercial real estate:
Although there are four classes, three of which are considered investable, the fourth is more speculative in nature.
So, each commercial real estate falls into any of the four categories below:
Class A commercial real estate asset
- Class A buildings are of the newest and highest quality. They tend to be less than ten years old. And, they are typically located in or near the Central Business Districts and/or most desirable locations of major cities. So, Class A properties are usually in metros like New York City or Los Angeles.
- Their locations are highly visible and have high traffic counts for both vehicles and pedestrians.
- These properties are with the most luxurious finishes, the newest technology, and the strongest amenity packages. For example, a Class A office building may have marble floors, high-speed internet, and outdoor amenities with fantastic views.
- Additionally, it may be highly energy-efficient as evidenced by a LEED certification.
- The properties of category Class A are newly constructed within 15 years and don’t require any major renovations. As a result, they command the highest rental rates. And, they are typically only affordable for the most profitable companies or highest income earners.
- On a per unit or per square foot basis, they command the highest sales prices with cap rates typically in the 4% to 5% range.
- These properties are considered to be the least risky investment class due to their high-quality tenants, physical condition, and stable cash flow supported by their high-earning tenant base.
Class B commercial real estate asset
- Class B buildings are well maintained but maybe slightly dated and in need of light renovations. They are usually between 10 and 20 years old and typically located in a good, but not great markets.
- These properties may have tile floors, laminate counters, carpet in the bedrooms, and a slightly outdated fitness center.
- The properties belonging to Class B tend to be in good condition with fully functioning mechanical and HVAC systems, but may need light repairs or modernization.
- The rents of Class B are lower than Class A and are typically within reach of small to medium businesses and median-income earners.
- On a per unit or per square foot basis, sales prices are lower than Class A properties and returns consist of a mix of price appreciation and income.
Class C commercial real estate asset
- Class C buildings are older vintage, dated, and in need of moderate to significant repairs.
- They are between 20 and 30 years old.
- Also, they are typically located in less desirable areas. So, they are far from major highways, shopping districts, and employment centers. Hence, they are often inaccessible by public transportation.
- These properties have dated finishes that are in need of replacement. This is because they are obsolete or non-functioning. These include repairs to mechanical systems like roofs, parking lots, HVAC, or plumbing.
- The rents of Class C are lower than Class B and within the reach of small companies and hourly workers.
- The properties belonging to Class C are less expensive than Class B on a per-square-foot or per-unit basis.
- They carry an elevated level of risk due to higher capital investment. Moreover, the tenants are usually low-income people.
- Properties of the Class C category offer an attractive opportunity for investors offering elevated risk tolerance and the operational expertise to execute a modernization program.
Class D commercial real estate asset
- Class D properties are highly speculative and not considered an investment grade.
- These types of properties are outdated and in need of significant repairs or a complete rebuild. They are more than 30 years old and located in very poor areas without access to transportation networks, restaurants, grocery stores, or other amenities. In addition, the location may be in an area where crime is an issue.
- These properties have very dated finishes that need to be replaced. They need a complete renovation or tear down of the building.
- The rents of Class C are affordable but they remain vacant due to their conditions.
- On a per-square-foot basis, Class D properties are the most affordable and they carry the most risk.
- These properties can be acquired at an attractive price, but the capital investment needed to bring them to market standards can be significant and it can be months or years before the investor sees any sort of return in the form of income or appreciation.
The Lilypads Bottomline:
Choose wisely before investing in one of the suitable property classes in commercial real estate
The property class investors choose can have a great deal of influence on the stability of an investment over time. Also, it affects the growth appreciation. Therefore, it is ideal that commercial real estate investors add properties to their portfolios in accordance with their individual risk tolerance.
However, it is evident that Class A commercial real estate assets are inherently safer investments than Class B or Class C assets. Since Class B and Class C properties demand a more hands-on approach with renovations and higher up-front capital investments, these investments may suit only the most adept and experienced investors.
But, again, investors having a higher risk tolerance can select Class B and Class C assets as they trade at higher cap rates and generate higher returns than Class A assets. On the other hand, Class A investors can preserve their investments as they are investing in top-tier properties.