Classifying real estate is one of the most fundamental ways to understand risk and reward, and the future potential of any real estate investment.
Buyers, sellers, lenders, and sometimes even tenants use real estate property class as a way to determine the pros and cons of investing or renting.
In this article we’ll look at the four most common property types and the pros and cons of each.
What are Real Estate Property Classes?
Professionals in the real estate industry separate property into four different classes:
Real estate classes are similar to getting a good grade in school.
Generally speaking, the higher the property class is the better the property is. However, while real estate property classifications sound simple enough, knowing whether a property is A, B, C, or D can sometimes be complex.
Part of the reason it can be difficult to classify property is because classes differ from market to market. For example, a Class A property in a smaller city like Memphis might be considered a Class B or Class C property in a major metro area such as Miami.
Even within the same real estate market, there can be a certain amount of subjectivity used to assign a property a specific classification. It can also differ when comparing property types, like single-family vs multifamily vs commercial real estate.
A house that one investor considers to be Class A might be a Class B to another investor, simply because the yard is too small or the location isn’t perfect, at least in the opinion of the second investor.
General Guidelines for Class A, B, C, and D
While there are no industry rules used to classify real estate, there are some general guidelines to follow to know which class a property belongs in.
- Age and condition: Built within the last 10 years or less, or completely renovated. High-end finishes and landscaping.
- Location and amenities: Located in desirable areas or gentrifying neighborhoods. School districts are highly rated, a variety of shopping and recreation is close, and public transportation is within an easy walk in urban locations.
- Investment characteristics: Tenant quality is normally highest with high income earners and vacancy rates low in Class A property. Maintenance costs are usually lower too. Because of the reduced risk, purchase prices are higher creating a lower level of cash flow. A good option for the buy-and-hold investor looking for a predictable income stream.
- Age and condition: Between 10 and 20 years old. Well maintained with little or no deferred maintenance and above-average finishes.
- Location and amenities: Neighborhoods are good with relatively low crime rates, and school districts are above average. Good access to shopping and recreation.
- Investment characteristics: Tenants are generally middle-income earners who take pride in where they live. Class B property can be a good workforce housing investment, with relatively reliable cash flow and longer-term renters. May also offer a good value-add opportunity, by renovating the property and increasing rents as the market allows.
- Age and condition: Between 20 and 30 years old or older, with deferred maintenance and below-average finishes. May require capital repairs such as a new roof, HVAC, or furnace.
- Location and amenities: Neighborhoods are generally lower income, with mid-rated schools and a higher percentage of renter households. Basic amenities such as small groceries and community parks may be in the area, with transportation required to reach major shopping areas.
- Investment characteristics: Property prices and rents are lower because property is located in a less desirable area. Tenant turnover and bad debt will likely be higher, although Class C property may offer a higher level of cash flow. Potential value-add opportunity to renovate into a Class B property, depending on the dynamics of the immediate market.
- Age and condition: 30 years or older, or property that has been seriously neglected by the current owner. Class D houses need a significant amount of repair or may even be completely uninhabitable until they have been brought up to code.
- Location and amenities: Lower income areas where rents may be subsidized. Little or no access to nearby amenities. School districts below average and higher crime rates, with the percentage of renter households approaching 100%.
- Investment characteristics: Class D property may provide a good opportunity for the short-term fix-and-flip investor, especially if the house is located in a Class C or B neighborhood. Purchase prices, rents, and tenant quality are the lowest among the four real estate classes. Property management and expenses are also higher, although potential yields may also be strong due to a greater rent-to-price ratio.
Risks and Rewards of Class A, B, and C
Different real estate classes also offer their own unique mix of potential risk and reward. Class D real estate is often thought of as being in a class of its own, due to the high level of risk. That’s why the majority of rental property investors focus on A, B, and C real estate.
Understanding the pros and cons of Class A, B, and C can help ensure you’re purchasing the right property class to best match your investment strategy and rental property portfolio structure.
Among the three classes, Class A real estate may be viewed as the safest investment option due to the newness of the property and higher quality of tenant.
Because Class A property costs more to purchase, cap rates and net income are generally lower. Potential appreciation may also be less than Class B or C. During an economic downturn, the higher income earning tenants attracted to Class A rental property may suffer more than workforce tenants in B or C real estate.
Financing Class A real estate is usually easy because lenders see less risk in a newer property. Interest rates may be lower, and the lender may not require a capital reserve account because the likelihood of repairs and tenant vacancy is lower.
Rental property investors often view Class B real estate as offering the most balanced blend of risk and reward.
Because purchase prices are lower, Class B property can offer a higher cap rate and yield in exchange for the slightly higher risk of buying an older property in an average area. The potential appreciation of Class B real estate may also be greater, generating a higher total return of cumulative net cash flow plus profit from appreciation.
Financing Class B real estate can also be easy for borrowers using a conservative LTV of around 25%. Lenders often view B property as having more potential risk. But by making a larger down payment, an investor can earn more favorable loan terms to help keep cash flow strong.
Class C is the riskiest type of investment due to the property condition, location, and higher potential for problem tenants.
However, this lower class of property may also offer a good upside opportunity for the well capitalized, experienced real estate investor with a strong local real estate team. By purchasing neglected property in a good area, a Class C property investor may be able to add value through rehabbing and raising rent to market to increase cash flow and overall returns.
Because of the higher risk and potential need for costly repairs, financing the purchase of Class C real estate is often done through a joint venture or a private lender. Although interest rates and fees are higher, loan terms are shorter. After the property is repaired and cash flowing with a reliable tenant, many traditional lenders will offer a loan with a lower interest rate and 30 year term.
How to Search for Properties by Class
Four key criteria you can use to search for Class A, B, or C real estate:
- Property age
- Neighborhood rating
- Cap rate
- Percentage of renter households
Each of these key variables interact with one another.
For example, a new Class A house in a 5-star neighborhood will generally have a lower cap rate because the property price is higher, and the net income is lower. On the other hand, a Class B property in a 3- or 4-star neighborhood will provide a higher cap rate because the net income is greater, and the purchase price is lower.
There are a number of ways to look for potential real estate investments by class.
If you have a real estate agent on your team, ask her to run a report from the MLS of houses on the market built during a specific time frame. Or, you can search the internet for cities with a high percentage of renter households then go to Zillow and try to find an available house in the market you’re interested in.
Unfortunately, both of these methods are hit and miss, and take a lot of time and effort. And as successful real estate investors know, time is money.
Fortunately, it’s easy to find the real estate class you’re looking for by using Roofstock's Marketplace. Search criteria you can use to find Class A, B, or C property on Roofstock include:
- Neighborhood ratings from 1 to 5 stars
- Average school ratings from 1 to 10
- Property with high cap rates
- Property with higher yield
- Minimum year built