What are A, B, C, and D properties?
The different letters in multifamily properties are similar to grades you receive in school. So what determines a property’s grade?Well, a property’s grade or class is determined mostly by its quality, age, and location. A properties represent new and high-quality properties. B properties represent properties that are not as good but still decent. C properties represent properties that are typically older and in need of renovations, and class D properties represent properties that are run down, and in need of significant repairs.
How location and age affect a property’s classification
- To be an A property, the property must be in a good location with low crime rates and high income. In general, these properties were built in the last 15 years and are in or nearby big cities.
- B properties are typically in an acceptable, but maybe not the best location. They also tend to be no older than 25 years old.
- C properties can be found in areas that are not that desirable. In terms of age, these properties are generally more than 25 years old.
- Lastly, D properties are located in high crime rate areas with low-income. In addition, properties like this are much older and have been occupied for many years.
What do the different classifications mean for investors?
All of the different classes of properties represent varying levels of risk and reward. Properties in the class A category are usually safer investments because they are in good condition and in a booming market. However, properties like this normally have low capitalization rates, which makes it harder to generate a high return.
When it comes to class B and C properties, they aren’t as safe when it comes to investing and might need repairs here and there. In addition, they are in lower-income neighborhoods with lower-income tenants. But, if you are willing to take the risk, you can likely generate a higher return and these properties have higher cap rates.
Finally, class D properties are normally the riskiest investments. Because of their undesirable location and higher crime rates. In general, these properties may not appreciate as much as the other classifications. However, these properties normally have a low purchase price and can command high rents. For that reason, cap rates can be high. This high cash flow comes at a price. Normally, these properties require a high-touch approach and require a bigger effort to manage.
The 50% rule
The 50% rule in real estate can help you to quickly estimate how profitable a property will be. Although it isn’t the most precise method, it can give you a good idea of what to expect.
Basically, what this rule states is you should only purchase properties where you can expect to keep 50% of the gross rents for the property. In other words, 50% of the rent or less should go to the property’s operating expenses. These expenses can include repairs, maintenance costs, taxes, owner-paid utilities, etc. However, normally the 50% rule does not include mortgage payments or property management expenses.
For example, if a property generates $3,000 monthly, you should only buy properties where you can receive $1,500 in profit after all expenses are paid.
Lastly, make sure to keep in mind that the 50% rule is only a guideline, and you may be able to be successful in purchasing properties where your expenses are slightly more than 50% of the property’s gross income.
Why do people invest in class A properties?
Class A properties usually always have low cap rates around the 5% to 6% range, meaning that you are barely making any money. But, even though these properties aren’t that profitable, they are still being bought. Here are a few reasons why people like to own class A properties:
- Safety – Because these properties are normally in a good location with high-income tenants, it is rare that the value of these properties goes down.
- Rent – It is easier to raise rent prices in higher-income neighborhoods than in any other neighborhood.
- Demand – Since these properties are in desirable locations when selling these properties, there is normally high demand to purchase these properties.
- Status symbol – If an investor is already wealthy, why wouldn’t they invest in the best markets possible? Similar to how individuals enjoy owning luxury cars and watches, some people just enjoy buying fancy apartments. Additionally, they typically aren’t looking for positive cash flow, they are looking for safety.
In summary, there is no right or wrong answer when it comes to deciding what class of properties you should buy. The answer will likely be guided by your investment style, your desired level of safety, and your rate of return.