Not all commercial real estate properties are equal. Investors must consider if a new luxury building with cutting edge design, sumptuous materials and indulgent amenities may be a better investment than an older property that was once equally significant and has a long track record of profitability. That’s why a well-recognized property classification system exists that categorizes buildings as Class A, Class B or Class C.
This system matters because each category has different levels of risk and return, and knowing each categories’ characteristics helps investors determine if a property can meet their investment goals. In our experience conducting exhaustive due diligence and underwriting assessments on hundreds of properties, class also helps us compare properties to the competition—namely other buildings that will compete with them for renters.
However, definitions of each class and the differences between properties in each tier can be remarkably hazy. In truth, there is no hard-and-fast line between Class A and Class B or Class C, and the criteria for each category varies by market. A Class A building in a Gateway City like Boston, San Francisco or New York will be very different than the emerging real estate markets we consider the best places for investment, such as Denver, Austin or Charlotte. In general, we’ve found that properties are largely assigned to Class A, B or C based on its location, construction, age, or quality of its tenant. Here’s what we look at in each of these four fundamentals.
Location: Mapping High-Demand Turf
The most common way to classify commercial rentals as Class A, B or C is by location. Market snapshots from CBRE, JLL and other brokerage firms separate downtown office buildings and infill multifamily property from suburban properties in less demand. Or they’ll specify city locations inside and outside the central business district, and suburban submarkets in the highest demand.
Geography is useful in classifying real estate because distance from downtown often establishes their value. In our home base of Chicago, prime real estate in the Loop and River North is at the top of a pecking order and thus buildings in the area receive a Class A rating, followed by surrounding locations—the South Loop, West Loop and Lincoln Park. A property in the South Loop can’t command the same rental prices as a building of the same quality in River North.
Through this lens, Class B properties lack only the central city location with its walkability and access to transit, retail, restaurants and entertainment. Class C indicates an outlying neighborhood that offers value, perhaps for its distance from the central city or proximity to schools, shopping, parks or specific amenities.
Construction and Age: Shiny New Things
New construction commands premium rental prices. A new building can be customized or even configured to specific tenant needs, from the latest amenities (think coffee bars, pet care areas, inside/outside recreational features, etc.), technology and up-to-date finishes to programmable spaces and more green space. For that reason, Class A multifamily apartments and office space often indicates a building less than 10 years old.
Construction quality and continued upkeep can keep a property in this top rank. But if a new property—from a multifamily development to an office tower—rises across the street, it likely will be nicer and command higher rents. Newer buildings also tend to have trendy finishes, better amenities and a heightened tenant experience.
Class B buildings, generally 10- to 20-years old, can be upgraded with value-add renovations to compete with Class A buildings, or offer renters a more economical option. This can be especially effective in areas where worker housing is in high demand. But even an older building with multi-functional floor plans, high-quality finishes and desirable amenities will lose its market presence over time.
Tenant Quality: Who’s Moving In?
Buildings also can be defined by who rents them. Many multifamily tenants are renters by choice, not necessity, and are college educated, have the credit scores to qualify for a mortgage and they can pay upwards of $2,000 a month. Marquee companies are drawn to prestige downtown office buildings. Both these types of tenants are most likely to choose Class A buildings.
On the other end of the spectrum, companies that operate with low profit margins have a lean cost structure and pay workers less. Those companies and workers must lock in the lower rents of a Class C building. Affordability is the main attraction of a Class C property.
In the middle are Class B office parks and professional buildings, and multifamily property that can accommodate families looking for good schools and lifestyle amenities.
Class Distinctions: Which Is the Best Investment Property?
Investors can make money on all three property classes. Class A properties provide the highest, most stable income. Their tenants have the means to pay for a posh address, and often will sign long-term leases—especially in office properties. For investors, revenue is highly predictable in the short term, but may leave little room for rent increases—particularly in markets with growth in new construction.
A long-running building boom has made Class B more productive in recent years, the National Apartment Association says. With a 3.5% average rent increase, Class B sets the pace the market, although luxury rentals are closing the gap. Class C properties can be successful with a no-frills operation that allows for more vacancies. Job turnover will affect tenants’ ability to pay and raise the chances of eviction.
Many investors see their best option in a project that allows their building to move up in class—a solid Class B building that with an infusion of capital can execute a value-add renovation that brings it into competition with its Class A neighbors—and allows for higher rents. Such an upgrade can be successful with a realistic business plan–and management skill at the head of the class.