For newbie investors, picking out a multifamily investment property can be challenging. Unlike a personal home, commercial property is purchased to be used by tenants, so it can be hard to know what to look for.
Will they prefer a full second bathroom or half bathroom, a tub or a shower?
Do they want a property in the busy area of the city or a quiet suburb?
These are some of the questions you will have but may not be able to answer.
However, the first step to identifying your ideal property is to define your target area or location. Knowing the area where you want to buy will reduce your investment property wish list to only the best options within that area.
Different locations bring with them a certain target tenant base. This means that you may pay more to be in a particular, more desirable part of town and hopefully that translates to higher rents and maybe, less hassle when it comes to the type of tenants that will rent from you. Tenants with good credit and financial stability are likely to rent an apartment in more desirable locations where properties have differentiated amenities.
Our two main criteria for our first rentals when we started out were cash flow and affordability. We did not start out with a lot of money and needed to be in an area where we could afford to buy and where we could still ensure that the properties cash flowed. It was a lower middle income neighborhood with many employment options but where the schools were not so great. In the US property taxes are used to fund the schools. This meant that the properties were not as expensive as they would be elsewhere. The rents in our first investments could support the mortgage payments, the expenses, and left a little extra cash flow at the end of the month. This checked our initial investment boxes.
In multifamily real estate investment, properties are classified based on age, location, condition, and amenities. Like the school grading system, multifamily properties have a letter grade from an A to a D. The letter grade signifies the class of the property and suggests the features and amenities that come with it.
This article will walk you through the property classes and offer investment advice for each category. Read on to learn.
MULTIFAMILY ASSET CLASSIFICATION
Class A multifamily properties – Grade A is assigned to top-tier properties. Typically, these properties have all of these characteristics;
- 0 – 10 years old
- Located in a primary market
- Possess several modern amenities
- Great condition
It is important to note that Class A properties can be over 10 years old. In this case, the factors that give the property Class A status are location, amenities, and tenants. A well maintained 20-year old multifamily property in a business district has a better status than a newly built multi-apartment in the suburbs.
Some of the factors that separate Class A properties from other property classes include:
- Location: Class A properties are always located in primary markets and areas with strong business activity. Usually, Class A properties are around offices, universities, and commercial hot spots. Also, they are easily accessible and have a conducive, secure environment.
- Condition and Amenities: Another distinguishing characteristic of Class A properties is the condition and amenities. Class A properties are usually in pristine condition, and they have several functioning amenities such as pools, doggy daycare, laundry, gym, and perhaps a restaurant.
Investment Advice: In terms of risk management, Class A properties are considered low risk. That is because Class A properties are sought out by professionals, high income earners and business persons.
The primary challenge of acquiring Class A properties is the cost of the asset. Class A properties are pricey and in demand among many investors, often foreign and institutional investors.
Only wealthy individual investors can buy a Class A property conveniently. Others use the leverage offered by real estate investment firms to own a stake in a commercial property.
That said, Class A properties command high rent compared to other property classes. Based on the high demand for this property class, it is easy to sell or rent out.
However, Class A properties are not without their risk. The primary risk of Class A properties is oversupply. That happens because too many developers are only interested in building Class A properties to maximize their profit. In an uncontrolled market, this practice can create a supply glut.
Class B Multifamily Property
Age, condition, location, and tenant demographic are the primary characteristics that make a multifamily property Class B.
Class B buildings are typically over 10 years old but less than 30 years old. They are located on the outskirts of prime areas and are generally in good condition. Sometimes minimal repairs or upgrades may be required to raise the rent value to the market standard. For example, a Class B property might need a façade and common area improvement or a landscape upgrade.
Generally Class B properties have fewer amenities than Class A assets. They command slightly lower rents than Class A but often the lines are truly blurry. Usually, this type of property has a strong middle-class tenant base of white-collar and blue-collar workers. These properties are nice and desirable places to live.
Investment Advice: The cap rate of Class B properties is always higher than Class A assets. That means that Class B assets cost a little less and offer higher net operating income. That is because the rent for Class B properties can appreciate when the property is improved. For this reason there tends to be high demand for Class B assets.
The main risk of Class B properties is competition. Sometimes, Class A assets can be downgraded to Class B, automatically becoming a strong competition to existing Class B properties.
Class C Multifamily Property
Real estate assets in the Class C category are lower than Class B properties in terms of age, condition, and location. A true Class C property is over 30 years old, located in a less desirable area, and needs significant redevelopment to become functional.
Most Class C properties show visible signs of wear, such as worn exterior, visibly in need of upkeep, and overgrown landscape. Because they are over 30 years old, these facilities don’t have the modern amenities demanded by high-end and middle-class tenants. Class C properties are sought after by people with fewer means.
Investment advice: Even though Class C properties need fixing to become rentable, they have the highest profit potential out of the three property classes. Savvy real estate investors focus on acquiring Class C properties because of the high cash flow potential.
The great strategy for Class C properties is to purchase these assets in Class B locations. Such deals are always profitable because the investor can improve the property to Class B standard and demand Class B (higher) rent.
Class C properties are not without their risks as well. They require significant capital and intensive management to become profit-generating assets. Newbie investors may not want to or may be unable to meet this requirement because they may not have the excess capital required, may not have the skills needed or may not have the time necessary to execute the turnaround.
In this case, the practical solution is to use real estate investment and asset management firms to acquire and manage the property.
Class D Multi-family Property
Class D assets do not have the qualities of assets in higher property classes described above. They are located in places you would naturally avoid because of security concerns. These properties are over 40 years old and always run down with few functioning amenities.
The typical tenants in Class D properties are people with poor credit, unstable job histories, often people on government subsidy. Most of the renters are by necessity, and in the event of an economic downturn, would lose their jobs.
Investment advice: Class D assets are not popular among newbie investors because of the high risk. They are for experienced investors only. Some seasoned investors may have a proven strategy to upgrade and manage Class D properties but even then there are many risks to navigate.
In commercial real estate investment, multifamily properties arguably have the best (lowest) risk margin. However, multifamily real estate investment is challenging for individual investors to access for many reasons.
One of the primary reasons is it is capital intensive. An investor must have deep pockets to own a multi-apartment property. Also, this product type requires intensive management. These factors deter most individual investors from multifamily real estate investment.
Smart individual investors partner with accredited real estate investment and asset management companies, who pool capital to invest and manage real estate properties.
Always keep in mind that the best real estate and asset management companies have a proven track record, high transactional experience in dollars, and a sound strategy for investment. To find out what we have to offer at Cape Sierra Capital please reach out to us.