In a commercial real estate investment, two of the major drivers of risk are the condition of the property at the time of purchase and its specific location. For example, a new or like new property with an excellent location carries much less investment risk than an older property in a subpar location. To help investors identify key risk characteristics associated with a commercial property, the investment industry has devised a generally agreed upon classification system that acts as a shorthand for risk.
In this article, we will describe what the risk classification system is, why it is important, and the specific characteristics that go into each category. With this information, readers will be able to quickly and easily identify risk and property location characteristics and use this information as part of their pre-purchase due diligence process.
At First National Realty Partners, we typically purchase Class B or Class C assets and renovate them into Class A. Doing so de-risks the property on behalf of our investors and can boost returns and rental rates. To learn more about our current investment opportunities, click here.
Property Ratings Explained
Commercial property ratings are part of a classification system designed to help lenders, real estate investors, and other market participants quickly identify the risk/return profile of a property or potential investment. In the ratings system, properties are assigned a letter grade, A, B, C, or D that is indicative of the property’s risk profile.
It is important to note that the boundaries between these letter grades are not official and there can be some grey area. As such, ratings should be taken with a grain of salt and as “directional” in nature, not an officially sanctioned rating from some third party company.
Below are details on the four major property rating categories.
Class A Properties
In a sentence, Class A properties are the newest, the best, and the least risky.
Class A buildings tend to be less than ten years old and have an excellent location in or near the central business district and/or most desirable locations of a major city like New York or San Francisco.
Class A properties also have the highest quality finishes, the newest technology, and the most luxurious amenity packages. As such, they require little or no renovations and command the highest market rents and generate the most rental income on a monthly basis. They also tend to be the most expensive.
Class A properties typically sell for cap rates in the 4% to 5% range and offer similar returns on an annual basis.
Examples of Class A properties include downtown high rise office buildings with high end finishes like marble floors and high speed internet access or a multifamily property in a fashionable suburb with a full amenity package that includes a swimming pool, fitness center, and common area for residents.
Class B Properties
In a sentence, Class B properties are good, if not great assets that can offer investors a compelling mix of value and return.
Class B buildings are well maintained properties that may be slightly dated and in need of minor renovations. They typically have an age of between ten and twenty years and have good, not great locations.
Class B finishes may be slightly dated, think laminate floors, tile counters, or worn out carpet. Major mechanical systems like HVAC, electrical, and plumbing are in good condition, but may need light repairs or modernization.
Location-wise, Class B properties have good locations near major interstates and transportation hubs. They may not be located right downtown or in the most desirable neighborhoods, but they are close in secondary locations.
Given their slightly dated condition, Class B properties may have some execution risk around renovations. Thus, they tend to be less expensive than Class A properties and offer higher return potential, usually in the 5% – 10% range.
Examples of Class B properties are older industrial properties or inline retail properties in need of some slight renovations.
Class C Properties
In a sentence, Class C properties are older, in need of repairs, and in fair locations.
Class C properties tend to be between twenty and thirty years old and/or may have inferior locations that are far from transportation arteries, shopping districts, or employment centers. They could also be located in tertiary real estate markets, away from big cities.
Class C finishes are out of date and must be replaced because they are either worn out or not consistent with modern day standards (or building code). Major mechanical systems like plumbing and the roof may need to be replaced completely. In addition, they may have tenants with expiring leases and/or existing vacancy.
Often, Class C properties are targeted by “value add” investors who seek to purchase them at a good price and invest a significant amount of capital updating the property to bring it to Class A or B standards. When executed effectively, this strategy can yield significant returns, in the 10% – 15% range annually.
Class D Properties
For most individual investors, Class D properties are below investment grade. They are properties that need to be completely overhauled and/or demolished and rebuilt. They represent a classic boom/bust scenario and we do not recommend them for individual investment.
Why Understanding Property Ratings is Important
We want to highlight two reasons why understanding property ratings and building classifications are important.
First, they help individuals quickly identify investment opportunities that are a good fit for their own risk tolerance. For example, investors with a low risk tolerance who don’t want much volatility would probably be a good fit for Class A properties. But, if an individual has a longer term time horizon and is comfortable with some level of risk, they could invest in a Class C, value-add project.
Second, they act as a filter to help investors sort through deals. For example, if an investor only wants to look at Class B shopping center deals, they can immediately set aside any opportunity that does not fit this description.
Investing With a Private Equity Real Estate Firm
With the points above in mind, it is helpful to point out that private equity real estate firms have a variety of investment strategies, many of which focus on a specific CRE asset class or property type. When investing with a private equity firm, this classification system is again helpful to help identify one whose strategy is a good fit for an investor’s individual goals and objectives.
For example, our strategy is to purchase Class B or C grocery store anchored retail centers in strong real estate submarkets and to invest capital in high quality upgrades that attract new tenants. Over the long term, these investments can improve property cash flow and deliver strong investment returns. So, investors who agree with this thesis may be a good fit for one of our deals.
It is important that all investors who work with a private equity firm take the time to understand their investment strategy and the classification of properties that they invest in. Doing so allows an individual investor to partner with firms that have a similar vision to their own.
Summary & Conclusion
To help investors quickly understand the risk characteristics associated with a commercial property investment, the industry has developed a property rating system.
Class A properties are the newest and best with a great location and state of the art building techniques and finishes. They are also the least risky, most expensive, and deliver low, but stable returns.
Class B properties are slightly older, may need light renovations, and may have some tenants with expiring leases. As a result, they also tend to be less expensive than Class A properties and offer higher returns.
Class C properties may be in slightly less desirable areas, have a long backlog of needed repairs, and may have some existing vacancy. For this reason, they come with higher risk, but also have the potential for a higher return.
Class D properties are those that need a complete overhaul or demolition and replacement. These represent a classic boom/bust scenario and are not recommended for individual investors.
These classifications are important to help investors identify properties and deals that are a good fit for their own investment objectives.
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.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.
