As the awareness of the benefits of multifamily investing increases, many investors are asking about the different types of asset classes. This is a very important question as the various asset classes have different risk and return profiles. Investors should understand these differences to ensure they select investments that align to their goals and risk tolerance.
In the multifamily world, there are generally 4 different asset classes: Class A, B, C and D. Properties are generally graded based on physical characteristics and year of construction. There is no uniform definition for these asset classes and it is quite subjective based on who is delivering the information. We describe the characteristics of each class below:
Class A properties are the generally very new, highly amenitized with all the bells and whistles and located in good infill and suburban locations.
- Built in last 10-15 years
- Luxury apartments with high income tenants (white collar)
- Highest rents in submarket
- Located in strong areas with access to premium retail, good schools, etc.
- Little deferred maintenance
Class B properties are a step down from Class A and are very functional but may have out of date amenities. These are generally more suburban and/or on the edges of core areas of cities.
- Built between 15 and 30 years ago
- Functional apartments with average income tenants (gray collar)
- Mid Level Rents
- Could have some deferred maintenance and/or have ample upgrade potential
Class C properties are true work-force housing that caters to the renters by necessity tenant base.
- Built between 30 and 50 years ago
- Usually have some functional obsolescence (e.g. ceiling height, floor plans, mechanical systems, etc.)
- Generally lower income (paycheck to paycheck) tenants (blue collar)
- Often ripe for upgrades and value-add strategies
Class D properties are generally very low income housing in lower socioeconomic areas.
- Built 40+ years ago
- Generally have tenants that are subsidized by housing / government vouchers
- Often located in higher crime neighborhoods that require significant management and security
- Often have substantial deferred maintenance and vacancy issues
How Do the Various Asset Classes Impact Investors?
As you can gather from the above, each asset class has a different risk profile. Since Class A assets are newer, located in good locations and have a high income tenant bases, these inherently are less risky. Contrary to Class D assets that are tough to manage, are older and in high crime areas, making them higher risk.
As such, generally investors would expect to receive higher returns if investing in Class D assets versus Class A assets. The basic premise of higher risk implying higher returns in investing is applicable here and this can be evidenced by the different cap rates for each asset class. As discussed in the article Why Cap Rates Do Matter, cap rates are a measure of risk. Therefore, Class A assets have lower cap rates (i.e. high prices) than Class D assets (i.e. lower prices) to reflect the differences in risk. Class B and C assets would have cap rates between those of Class A and Class D.
Generally speaking, most value-add investors in the multifamily space focus on Class B and C assets as they offer the best risk-adjusted returns. Opportunities exist to find Class B and C assets in decent locations that can be upgraded (e.g. curing deferred maintenance, new interiors, new branding, etc.) to appeal to a stronger tenant base, thereby increasing the rents, which ultimately increases the value of the property.
Are there also Different Classes for Locations?
It should be noted that location plays an important role in real estate and there are often different classes of location. Median incomes and average home prices are good indicators on location class. Usually Class A properties are in Class A locations (high income, well trafficked, etc.) and vice versa for Class D properties. However, there are often Class C assets located in “B” locations, which may provide further support to renovate the Class C asset to allure to the higher income “B” tenants in the area. This is one of the strategies we look for when we purchase properties as we know we have more control over improving a property than changing an entire area.
Understanding the various asset classes and risk / return profiles of each is imperative to making investment decisions. As an investor, it’s important to understand the context of who is relaying the information as they may have a bias. For example, brokers will often try to push up the asset class (e.g. classifying a C asset as a B) in their marketing materials to show a higher quality asset. Similarly, sponsors may do the same to passive investors when pitching their investment opportunities. Investors should be able to objectively make their own assessment on asset and location class based on the criteria above and see if the investment aligns with their strategy.