Commercial real estate (“CRE”) properties come in all shapes, sizes, conditions, and locations. While this is a major benefit for investors seeking a diversity of options, it can be challenging to describe them with a common methodology that allows an individual to compare one property to another. To solve for this issue, a common classification taxonomy has been developed that can be used as a shorthand for describing the condition, location, and risk associated with a given property.
The first descriptor that potential investors should commit to memory is the property type. Broadly, there are four types of commercial real estate properties: Office, Industrial, Retail, and Multifamily.
Office space is designed for the unique needs of running a business. The building may be a glass and steel high-rise located in the “central business district” of a big city like New York or a low or mid-rise property located in a suburban office park. In addition, the space could be general, meant to cater to companies like accounting and law firms. Or, it could be designed to meet the unique needs of a specialized type of tenant like a doctor’s office.
Office investors benefit from long term leases and generally low tenant turnover because it is difficult and/or expensive to move a business. But, those same leases may come with infrequent rental increases and expensive tenant improvements to entice a company to move.
An industrial property is characterized by properties with an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces.
Industrial investors benefit from predictable cash flow, lower operational risks, low CapEx requirements, and generally favorable supply/demand characteristics. But, industrial spaces can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
Retail properties are designed for tenants who operate direct to consumer businesses like clothing or electronics stores. Classic examples of retail properties include strip malls, shopping centers and standalone bank branches.
Retail investors benefit from high visibility and long term tenant leases. But, the financial strength of tenants can be impacted by changing market tastes and the interior of a retail property is often built for a specific purpose making the property difficult and/or expensive to re-lease without major renovations.
A commercial multifamily property is one with five or more units.
Multifamily investors benefit from relative stability in times of economic distress, but they may face challenges with high tenant turnover, short term leases, and increased collection expenses.
So, the first way to categorize a commercial property is by identifying the “type” and the risks and benefits that come with it. The next step is to identify the “class.”
Commercial Real Estate Building Classes
A property’s “building classification” is a shorthand description that can provide a potential investor with information about its: age, location, finishes, amenities, condition, rental rates, and sales price. While the exact boundaries between classes can be somewhat subjective, they are identified by a single letter: A, B, or C.
Class A buildings are the newest and highest quality. They tend to be less than ten years old and are typically located in or near the Central Business Districts and/or most desirable locations of major cities (like New York City). Their locations are highly visible and have high traffic counts for both vehicles and pedestrians.
Class A properties have the most luxurious finishes, newest technology, and strongest amenity packages. For example, a Class A office building may have marble floors, high speed internet, and outdoor patios with fantastic views. In addition, it may be highly energy efficient as evidenced by an LEED certification.
Class A properties tend to be in new, or like new, condition and don’t require any major renovations. As a result, they command the highest rents and are typically only affordable to the most profitable companies or highest income earners.
On a per unit or per square foot basis, they also command the highest sales prices with cap rates typically in the 4% to 5% range.
Class A properties are considered to be the least risky investment class due to their physical condition and stable cash flow supported by their high earning tenant base. But, they also have limited upside and tend to appeal to “cash flow” investors who prioritize stable income over price appreciation.
Class B buildings are well maintained, but may be slightly dated and in need of light renovations. They are usually between 10 and 20 years old and typically located in good, but not great markets.
Class B properties have average finishes that may be slightly dated. For example, a Class B multifamily property may have tile floors, laminate counters, carpet in the bedrooms. and a slightly outdated fitness center.
Class B properties tend to be in good condition with fully functioning mechanical and HVAC systems, but may need light repairs or modernization. Class B rents are lower than Class A and are typically within reach of small to medium businesses and median income earners.
On a per unit or per square foot basis, sales prices are lower than Class A properties and returns consist of a mix of price appreciation and income.
Class C buildings are older vintage, dated, and in need of moderate to significant repairs. They are between 20 and 30 years old and are typically located in less desirable areas that are far from major highways, shopping districts, employment centers, and public transportation.
Class C properties have dated finishes that likely need to be replaced because they are either obsolete or non-functioning. They are in fair condition and likely require repairs or upgrades to mechanical systems like roofs, parking lots, HVAC, or plumbing. Class C rents are lower than Class B and typically within reach for small companies and hourly workers.
On a per square foot or per unit basis, Class C properties are less expensive than Class B, but they carry an elevated level of risk due to the capital investment required and vulnerable nature of tenant income sources. However, they often present an attractive opportunity for investors with an elevated risk tolerance and the operational expertise to execute a modernization program.
Why Classification Matters
Simply, a property’s type and letter classification matters because it can quickly provide a potential investor with a significant amount of information and a way to assess the risk/return profile. Although the classifications can be somewhat subjective, they are commonly understood in the industry and widely used.
In addition, a property’s type and letter classification can provide investors with a valuable tool to filter through potential opportunities. For example, an investor may tell a broker that they only want to see Class B industrial properties. This information allows the broker to perform a targeted search on behalf of their client and narrow the options to those that most closely match the investors criteria.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
In our investment programs, we tend to employ a “value-add” approach, which means that we typically seek out Class B or Class C retail properties that we can acquire at a good price. Once purchased, we implement a modernization program that includes facade renovations, fresh paint, new parking lots, and the insourcing of all property management activities.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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