Investing in commercial real estate offers many pathways to profit. An investor can decide to take an active role in managing the property or take a passive role and leave management to someone else. There’s also variety in the types of properties available, with each offering a different mix of effort versus payoff. In some cases, a small investment in amenities can greatly increase residency rates. But, if you sink too much money into the wrong upgrades, you could end up losing money in the long run. Let’s take a look at asset classes, market tiers, and how to adjust investment strategies accordingly.
Class A properties are premium properties in high demand. They represent the most desirable in terms of amenities, location, clientele, and residency rates. Class A properties bring in the most revenue and are the newest, either just built or within 10 years of development.
A Class A property in a tier 1 market – like New York, Boston, Los Angeles, or London – isn’t the same as a Class A property in a lower tier market like Salt Lake City. If you were to move the same property between cities, the market may not support the rent you’d need to charge to make the building profitable. Without renters, the investment would ultimately fail.
Class A properties have the potential for more stable income but may provide a lower annual return because of the cost of capital. The risk here is that markets may change in the time it takes to secure funding and necessary permits to get the project off the ground. Most investors in this space are corporations that finance through high-powered investment banks, hedge funds, and bridge loans provided through traditional institutions.
Class B properties are older than those in Class A, but still bring in high to middle-income renters. The amenity mix could be aging and the property has been in use for 10 to 20 years. These are typically properties formerly in Class A that are showing signs of wear. Investors will have to spend some money on simple upgrades, whether they’re structural or cosmetic.
A Class B property will have a lower cost of capital because the investor doesn’t have to finance the initial construction phase. The exit strategy is key when selecting a lender. Do you want to buy and hold the property or fix and flip it? Hard money and bridge loans are the primary financial tools when it comes to Class B properties.
The next property class is older and requires a consistent maintenance and repair plan. Access to public transit, jobs, and shopping is an important consideration because renters are less likely to have access to a vehicle or an incentive to travel long distances for essentials. Keeping an eye on other developments in the market is also key. Urban core redevelopment and other similar changes can significantly alter profitability for this property class.
What’s attractive about Class C properties is that they can generate consistent and higher margin returns due to lower cost of capital and upgrades. It may only take a few contemporary upgrades to compete with other properties in this class. Because renters can get in at reasonable rates, investors have the potential to see higher returns than Class B properties. Financing strategies in this class are generally through ARV loans and portfolio loans.
Class D properties are typically in disrepair and may have been designed with lower-income renters in mind. This property class has seen 40 or more years of occupancy and could be uninhabitable at the time of purchase. High crime, neglect, and safety code violations are also prevalent in Class D real estate.
So, why would anyone invest in a Class D property? There are opportunities to leverage the building’s history, unique features, and low purchase price to redevelop it into a higher class. Investors must have stamina and accurate pro forma estimates to make redevelopment successful. The financial strategy for Class D properties is most often centered around redevelopment and sale to a property management company, for which bridge loans are ideal.
Just as there is a variety of property classes, there are several investment approaches to consider. Investors can choose a single asset class, pool properties, or work with a mix of asset classes.
Working within a single asset class will involve some of the strategies we’ve covered above. Within these classes and market tiers, there’s an opportunity to pool properties within the same financing tool. Mixing asset classes does take some skill and the advice of an experienced broker.
Combining investment in a Class A property with several Class B properties is one example of mixing asset classes. The higher margins from Class B properties can offset the capital investment of the Class A property. The cost of maintenance and repair of the Class B properties may be compensated for by the long-term returns of the Class A property.
Pooling properties provides the chance to combine assets to collateralize loans. This approach reduces interest rates by mitigating lender risk. Portfolio loans and ARV lenders are the primary ways of funding mixed asset-class investments.
When investing in multifamily properties or commercial real estate, a loan broker is your most valuable resource. Working with a loan broker helps you source capital structured to support your investment strategy. Brokers are adept at switching perspectives and offering solutions to find the best lender and mix of funding for your investment. Don’t hesitate to reach out today and find the right strategy, no matter which class or tiers your target.