There is a lot to consider before diving into real estate as an investment. You need to understand your own investment goals, and risk tolerance. You also should have an understanding of the market in which you want to invest, type of property you are eyeing, how much it is valued for – and the asset grade. Much like papers and school work are graded based on quality, real estate assets also come with grades, based on many factors.
Understanding a real estate property’s grade is important for you, as it can impact return, strategy and investment risk.
School grades follow a basic system. An “A” is given for superior work, while “D” papers or tests are considered close to failure. While asset classes also follow a basic grading system, their purpose goes beyond “superior” and “failed.”
For example, a run-down fourplex in a lower-income neighborhood and a four-unit, brand-new townhouse in a high-income location are multifamily properties. However, the townhouse could be considered a Class A asset, whereas the fourplex might be designated Class C or D. Neither of these assets are better or worse than each other. What the grades suggest are factors that could include (but aren’t limited to) location, amenities, age, finishes and rent.
To clarify the issue, Building Owners and Managers Association International (BOMA) developed building class definitions for buildings, specifically office assets. But BOMA’s categories can also apply to real estate product types as well. For example:
The Class A property is newer, and generally in an accessible location. In this case, “newer” is defined as anywhere from just completed to 10 years old. Class A assets offer high-quality standard finishes, above-average rents for the market, state-of-the-art systems and plenty of on-site or nearby amenities. Often called “core” or “core-plus” buildings, investors like these because of potential steady cash flow from generally low vacancies.
The Class B property is distinguished by offering average rents for its market, with fair-to-good finishes and appearances. While not as well-placed as their Class A counterparts, these buildings are in accessible areas. They might be further away from amenities, and older (up to 30 years old), with lower property values. Tenants often select a Class B property due to lower rents. For investors, Class B offers lower entry price points. Through repairs and upgrades, investors can increase rents, thereby potentially increasing the building’s value.
The Class C property is one that is older (30 years and above), with outdated systems that could need a great deal of repair. Sometimes they are far from amenities, though not always. Value-add investors like these properties a great deal, as the assets can be acquired for a low cost and turned around through upgrades and deferred maintenance repairs. Once the property is spruced up and occupancy stabilized (typically 90% or higher), the owner might sell it, and have the potential to make a profit.
There is also a Class D property grade, though you might not see this type of asset too often. The Class D property is distressed; it’s very old, and in dire need of repair. Suh properties can be found in declining areas and neighborhoods, with low-income and bad-credit tenants. They are the cheapest buildings to acquire, but can require a lot of capital investment and a great deal of TLC.
Property grades are fluid, depending on investors. A Class B property could be converted into a Class A-, if the property is being rehabilitated, with the owner having the capability of potentially pushing rents.
The asset grade that is best for your portfolio depends on your financial goals and the amount of risk with which you’re comfortable. For example, if you aren’t looking for an investment that requires major rehabilitation initiatives to potentially drive rents, you might want to ignore the Class D property.
To reiterate, there is no failure with property grades. Determining the right grade for you depends on your financial and investment goals, and comfort level with risk.