Commercial real estate applies a simple grading system to assets to rate overall quality and key characteristics. Buildings are classified as A, B or C, and that ranking is an important indicator to gauge a property’s competitive position in a marketplace and where it fits in relation to Market value is the price an asset would fetch in the public marketplace. In commercial real estate, market value can be impacted by the location of the property (major market versus rural), demand for that asset type (multifamily, office space, storage, etc), installed amenities and more.... More and rents.
Building class applies to all property types – industrial, retail, apartments, and hotels among others. Although by no means definitive, some of the accepted descriptions for the three different classes are as follows:
Class A Properties
This is the top tier in a particular market. Some of the key attributes of Class A properties include high-end construction and interior finishes, modern architectural design, state-of-the-art mechanical systems and technology and a variety of property amenities. For example, Class A office amenities might include valet parking, bike storage, and locker room facilities, an on-site restaurant or coffee bar and the latest in sustainable design. Class A multifamily properties in suburban locations, will almost always offer near resort-like settings complete with fountains, lavish pools, barbeque areas, and fitness centers. Class A properties are best-in-class assets that usually command the highest possible rents in their respective submarkets.
Class B Properties
Class B properties are a step down from Class A in terms of building quality, location, and amenities. While it is possible to have a brand new Class B asset, it is far more common that an asset becomes Class B due to age. Class B buildings are typically at least in good, if not great, condition and may achieve above-average rents, but rents and property values are lower in comparison to their Class A competitors. Also of note, historic assets (even if well maintained) are often rated Class B due to physical aspects that, while charming, are technically outmoded (e.g. single pane windows, small elevator cabs and lower ceiling heights). More specific to retail shopping centers, the quality of the tenant mix also can influence the class status for the entire property.
Class C Properties
This is the lowest rated tier and least desirable of buildings. Spaces within Class C assets are barely functional and are cheap to rent. Oftentimes, these are older assets that have outdated building systems, design or finishes, or they may be in desperate need of maintenance and renovations. Many Class C properties are in the waning days of their useful life and may be rapidly approaching functional obsolescence. For example, modern warehouse facilities are built with clear ceiling heights of 34 to 36 feet – about twice as high as was the norm back in the 1960s and 1970s. Companies such as Amazon want the biggest, tallest box to accommodate more efficient storage of goods. Some of the older warehouse facilities are simply not adequate for many of today’s tenants. Due to these types of constraints, Class C operators are often relegated to minimizing operating costs as a primary strategy since their revenue upside is limited. While a stock of real estate exists below Class C, it is generally not of investable quality and, therefore, does require classification.
Classifications are Subject to Change
Another important factor to note is that buildings can move down or up in classification. As mentioned above, a new building with state of the art amenities may easily start out as a Class A property but it may slip to Class B over time as the building ages, tenant preferences change or trade areas within a submarket shift. Conversely, it is possible to move a property up in class (e.g. from Class C to Class B or from Class B to Class A) through renovation and tenant repositioning. This is precisely the scenario that Properties are considered value-add when they have management or operational problems, require some physical improvements and/or suffer from capital constraints. By making physical improvements to the asset that will allow it to command higher rents – remodeling the kitchens in multi-family, installing more energy efficient heating systems in a medical office, etc. – improve the quality of tenants and increase... More investors seek opportunities where they can acquire a Class B or Class C property, make the necessary improvements or renovations and elevate its status. By doing so, owners boost cash flows, rents, tenant quality and, as a result, overall property values. Finally, retail centers, in particular, are highly location sensitive. A change in infrastructure or access can shift traffic patterns that create new “A” destinations, or even turn a previous premier location into a less desirable “C” location.
Once you understand the definition of asset classifications, it is important to contemplate how demand for each class of an asset type changes depending upon cyclical factors. Take, for example, the multifamily asset class. Class A properties can face two states of flux depending upon market and economic conditions. During periods of strong economic growth, Class A owners may find their turnover rates to be higher than normal as their best tenants vacate to buy homes, which are absorbed by former Class B tenants that are ready to step up to Class A living. During recessionary periods, Class A owners often increase concessions and even lower rents to retain tenants who, otherwise, may look to move down to a Class B property to save money. It is due to these types of cyclical effects that Class B multifamily properties are often viewed as desirable investments because, regardless of the economic cycle, Class B assets benefit from their middle-market position, meaning that there is usually an even balance of tenants entering and exiting the asset class.
Asset Class and Returns are not Correlated
In most cases, asset class and returns are not correlated. However, to the extent that loose correlation may exist, it’s usually inverse. As one of my former colleagues would humorously (but accurately) point out when evaluating a potential Class C acquisition, “we’ve made more money over the years owning junkyards than museums”. More important is knowing where a property fits within the asset class ranking system and where it is headed given a particular business plan. This helps to put investment opportunities into context in relation to potential risks and returns. In most commercial real estate markets, demand exists for all three classes of assets – the key is validating that a targeted property acquisition is competitive within its asset class and will remain so over the course of the holding period.
At a glance, the asset class system seems artless. Yet those categories can be subjective and also can vary widely depending on the individual market or region. For example, a Class A office building in a tertiary market may be viewed as a Class B building in a primary market such as New York City or Los Angeles. In addition, once assets reach the edge of a classification tier, they lose consensus when it comes to ranking them. Some might consider an asset as Class A- while others might view it as Class B+. The more an investor compares and contrasts competing assets, the better he or she becomes at calling the bluff of an overrated fringe asset or having confidence that an property is easily bumped to the next classification tier with the right amount of refurbishment.