An Introduction to Real Estate Asset Classes

Post by 
Josh Fischer

Should you focus on Class A, Class B, or Class C multifamily?

Investors interested in expanding their portfolios with the attractive risk profiles and strong returns of real estate commonly ask about the relative advantages and disadvantages of different multifamily asset classes and what type of real estate in which to invest. While a strong real estate portfolio will include exposure to a variety of asset classes, multifamily has historically served as the focal point of Birgo Capital’s investment strategy. Multifamily properties offer strong risk-adjusted returns and afford us the opportunity to utilize our operational expertise to improve returns via vertical integration. In particular, the composition of our newest fund leans strongly toward Class B multifamily buildings. 

It’s worth noting at the outset that no formal, universally-accepted framework governs the category that a particular real estate asset falls under. An investor who has assessed a given property as Class B may find that someone else identifies the asset as Class C. Regardless of this subjectivity, let’s break down the relative opportunities afforded by the different multifamily classes and discuss the implications each can carry for a real estate investment strategy.

Class A

Class A real estate is generally understood to consist of buildings that feature modern amenities and attractive locations in convenient parts of town. Especially in the multifamily space, luxury trimmings and proximity to popular shopping, dining, and entertainment hotspots are a priority within Class A. Rent in Class A is generally high relative to the market, therefore Class A buildings tend to attract higher-earning tenants than Class B and C.

Some investors interpret these traits as advantages, which results in expectations for Class A buildings of low risk and high exit valuations. In some sense, these beliefs are self-perpetuating. Strong investor demand may permit a Class A property to appreciate well over time with minimal capital outlay, and Class A buildings are unlikely to demand capital unexpectedly due to maintenance or collections issues. These traits work synergistically to increase the value-at-sale of Class A buildings.

Class A has, therefore, sometimes been regarded as a relatively low-risk investment space. At Birgo, we are not so sure that this is true today. In fact, some of the traits commonly ascribed to Class A multifamily properties can enhance investor risk and depress earnings. In a year plagued by, well, a plague, recessionary risk is an especially pertinent investor consideration. Initial demand for Class A properties may prove illusory over the long term because tenant demand for luxury housing is highly elastic: when times are good, demand for expensive units is great; but when times are tough, this segment tends to suffer. Vacancy rates for Class A properties have risen significantly in 2020, while Birgo’s portfolio of Class B and Class C properties preserved upwards of 95% of anticipated cash flow during Q2 and Q3. It’s clear that the potential for cash flow fluctuation in recessionary environments increases the risk associated with Class A’s typically lofty valuations.

Despite elastic tenant demand, investor demand for Class A properties tends to remain high — in part due to the increased competition for Class A properties from large, institutional investors. These high valuations — and concurrently low cap rates — are another complication for the apparently low risk of Class A buildings. High investor demand inflates purchase prices; consequently, it is no surprise that Class A properties often trade at lower cap rates than those common for Class B and C properties. But, low initial cap rates leave very little margin for cap rate compression: a low starting cap rate has nowhere to go but up, and increasing cap rates can damage asset values at sale.

Finally, high Class A purchase prices are sometimes offset with more leverage, driving up loan-to-value ratios and diminishing cash flow from the outset, as debt service consumes a greater proportion of collected revenue. Diminished cash flows narrow fund sponsors’ financial bandwidth for reinvestment, and sometimes cut into dividend payments — ultimately impacting investor returns.

Class B

The second type of real estate asset classes consists of Class B. Class B properties are, generally speaking, older than Class A properties; they may also be located in less-demanded parts of town, or — especially in the multifamily space — lack the latest popular amenities. For these reasons, Class B properties tend to trade at lower valuations and higher cap rates than their Class A counterparts. While many investors consider Class B a relatively safe asset class, there are still a few potential hurdles to be aware of.

Due to lower rents, Class B multifamily buildings may attract a younger, more transient tenant base. These young professionals are often interested in upgrading their lifestyles as their incomes increase, or they are simply more likely to relocate, which can occasionally increase Class B turnover. While this is not an insurmountable problem, it does suggest the importance of effective marketing strategies to maintain occupancy targets. A weightier issue that Class B investors need to be aware of is rent growth itself. Class B properties can be responsive to marketing strategies and renovations, but transforming a Class B property into a Class A property is not, in our experience, usually worth the expenditure, unless the property’s geography has experienced a significant increase in demand.

Despite the fact that Class B rent generally increases at a lower rate, Class B offers several compelling advantages. With respect to acquisitions, less expensive buildings tend to generate interest from a predominantly local investor base, reducing competition to purchase — and, therefore, price. Higher asking cap rates generally mean higher immediate cash flows, allowing asset managers greater optionality in reinvesting profits into building upgrades or making larger distributions. Especially for buildings in good repair, the combination of low purchase prices and near-term rent increases warranted by capital-light value add programs such as good property management and effective marketing can culminate in attractive cash-on-cash returns.

Additionally, because Class B multifamily buildings often serve as workforce housing, tenant demand is relatively inelastic in comparison to Class A. This insulates Class B investments from the kind of recessionary risk outlined above: when tenancy rates remain high, Class B cash flows — as opposed to those of their Class A counterparts — exhibit considerably less volatility. From a Class A renter’s perspective, the only direction available is down, so a recession might encourage a housing downgrade to Class B. Indeed, studies have shown that when foreclosures are on the rise, those who are foreclosed on often relocate to — you guessed it — Class B multifamily housing. From an investor’s perspective, these factors effectively replace vacancies that may be generated by other renters downgrading from Class B to C.

These advantages are augmented by a public policy consideration: while presidential politics have investors on the edge of their seats, both major parties in the United States have demonstrated that workforce housing security is a priority. If permitting workforce housing to fail falls outside the Overton window, all relevant parties’ interests converge to support subsidies which decrease the risk profile of workforce housing investments. For these reasons, Class B properties are, understandably, deemed by many real estate investors the Goldilocks of the multifamily space — an ideal balance of risk and reward.

Class C

Class C is the third type of real estate asset class. Class C properties, finally, are older than the average building in their market, located in less-desired locations or lower-income regions, and may present deferred maintenance issues. Rents and valuations are low for Class C properties, and expense ratios are higher than for Class B. These considerations can pose an array of distinct challenges relative to Class B properties.

First, Class C properties are unlikely to appreciate without intervention in the form of value-adds. However, value-adds for Class C properties can sometimes require significant capital outlay. Second, maintenance costs for Class C can — in the case of some buildings — be formidable. Finally, Class C properties may have higher delinquency rates, collections issues, or other property management complexities. These challenges converge to increase the average expense ratio on Class C properties, which can potentially narrow investor margins.

However, the unique attributes of Class C properties also offer significant opportunities: with the right investment and management strategies, these assets can generate compelling returns. First, the low acquisition cost of Class C properties yields strong cash flow. Second, a comparatively large prospective renter pool and shortage of affordable housing supply nationwide is a competitive advantage with respect to occupancy. Robust cash flow permits funds exposed to Class C to generate distributions relatively early in the investment lifecycle. Third, while vacancy rates do pose a problem for some Class C properties, these properties are often “low-hanging fruit” for capital-light value-adds. Marketing efforts are relatively capital efficient, and can significantly increase occupancy and rent. Birgo sees this time and time again: we buy a mismanaged property, market it properly, and rents immediately go up

While maintenance and property management pose legitimate challenges for Class C properties, the right strategies can mitigate these challenges. First, deferred maintenance or lower-end amenities mean that targeted capital outlay for carefully-selected properties can transform a Class C asset into a Class B one, substantially increasing value. Migrating an asset between classes is considerably easier at the lower end of the spectrum, and this strategy is a proven method to compress cap rate on sale. Location is a critical factor here (and one of the many reasons we love Pittsburgh-area real estate!), but the relative ease of migrating asset class is a great reason not to rule out Class C. Second — and especially for stabilized but underutilized buildings — full-time property managers and maintenance professionals are often decisive. While these services can be costly, their expense may be undercut by the right organizational structure. Birgo’s vertical integration brings property management and maintenance in-house, increasing property values and tenant satisfaction without breaking the bank.

Finally, while Class C properties may face increased rates of delinquency or evictions, they are also insulated by two unique forms of recession resistance. First, Class C tenant sources of income are more diverse than is the case for Class A and B properties. This effectively means that collections in Class C are dependent on a wider array of industries; consequently, Class C cash flows remain comparatively stable during downturns — especially those which affect only one or two sectors. Second, while Class A and B renters may, in recessionary environments, downgrade to Class B and C housing, respectively, Class C renters tend to weather downturns in place — especially given the political popularity of housing market relief.

Concluding Remarks

Of course, these considerations are not the full story on multifamily asset classes. And, exposure to a variety of asset classes can enhance the resilience of your portfolio. If you have additional questions about real estate classification, or are interested in discussing an investment with Birgo, schedule a call with us today.

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