Other Factors to Consider
Residential Rental Property Types
We touched upon this briefly above, but let’s elaborate: there’s a distinction to be made between “residential” rental property and “commercial” multi-family property. Residential rental property types include 1-4 unit rentals, including single family homes, condos and townhouses that are purchased by an individual and then rented to someone else.
These 1-4 unit properties do not fall within the same category of multi-family housing as the commercial product types discussed here today because they are classified for lending purposes as all being in the same category as single family properties.
Related: 7 Ways You Can Invest in Commercial Real Estate Online
Therefore, although properties with two to four units fall within the multi-family classification, because as the name would imply, there are multiple apartments within a single building, buildings with four or fewer units are generally considered “residential” rental properties because they are eligible for residential bank financing.
Properties with five or more units are considered “commercial” properties, and therefore, must obtain commercial debt. The terms for residential debt are typically more favorable than the terms for commercial debt, the latter generally being at least 50 basis points higher than the rates quoted for residential properties.
What are the Risks of Investing in Each Category?
As is the case with any investment, real estate-related or not, there are risks associated with investing in each “class” of multi-family real estate, including:
- Class A: One of the biggest risk with investing in Class A is one of oversupply.
As the market strengthens during real estate cycles, the price of land increases as do construction costs. As land values increase, the only way to make deals 'pencil' is to underwrite them to ever increasing rents which typically means assuming they will yield Class A type rents.
This in turn means that developers find themselves needing to build only Class A apartment buildings to stay in business as developers. This leads to oversupply and associated rent depreciation when markets turn down.
There’s also risk during boom times- as luxury tenants often have the ability to purchase their own housing and not rent, when times are good you run the risk of playing second fiddle to growing housing prices. We’ve seen a bit of this happening during the recent COVID-19 pandemic, as luxury apartments in dense urban areas sit vacant while well-heeled renters fled to the suburbs.
- Class B: One risk associated with investing in Class B real estate is the threat of competition.
If an influx of new, Class A multi family housing hits the market, the existing Class A inventory might be pushed into the Class B category, thereby creating increased competition for Class B housing. A secondary risk of investing in Class B multi family is not having the resources needed to maintain the property as it ages, and/or to execute the investors’ business plan to bring the property into Class A status, if that was ever the intention.
Some of this risk can be mitigated with the right location, but at the end of the day, you’ve got to be able to attract the right tenants- without the benefit of the very best amenities or the choicest location- that can be capital and time intensive, and a bit daunting when you’re not looking at the same gains from forced appreciation that you might see from a Class C property, or the highest quality tenants like you might find with a Class A property.
- Class C: The largest two risks to investing in Class C real estate is the cost of repairs and maintenance over time, and the lower credit and employment stability of tenants.
These buildings tend to need the most work and are at risk of becoming functionally obsolete if the owner does not make the necessary investments. The second risk to investing in Class C multi family, the quality of the tenant pool which tends to be lower income and potentially at highest risk of non-payment of rent (and therefore, eviction), can be particularly badly pronounced during economic downturns.
Tenants in Class C buildings tend to be lower paid workers who are more vulnerable to layoffs when the overall economy goes into recession. Class C properties command lower rents than similarly appointed Class B properties and won’t have the same kind of amenities as either Class A or B properties.
Many times, new investors in Class C properties have trouble with forced appreciation of a property. Forced appreciation refers to the steps individual investors take to improve the value of the property--things like renovations, business plan implementation, more effective marketing, reducing vacancies, etc. This is in contrast to natural appreciation, which is the rate at which the property appreciates in value based on market forces.
Managing any Class of property has challenges, but managing a Class C project on your own can be an incredibly time-intensive process. Investors who want to benefit from the high returns offered by Class C properties, but do not have the time or desire to get in the trenches themselves can work with professional management to take care of the heavy lifting. Even so, a competent owner will not rely entirely on a third party management company to control a property but will be active to some extent, especially where it comes to identifying areas for property improvement and security.
Related: Should You Invest in a Class C Property?
What are the Potential Benefits of Investing in Each Category?
We’ve touted several benefits of investing in multi-family real estate in general, but there are specific benefits to investing in each property class, including:
- Class A: These properties are generally the nicest and newest of the bunch, and therefore tend to need less maintenance.
Class A multi family also tends to attract the most desirable renters, such as six-figure earners and long-term tenants willing to pay a premium to live in these attractive properties.
Since you’re dealing with more discerning tenants, appliances, fixtures, and building features will be newer when purchasing a Class A property, so repair and replacement bills will be smaller- at least at first.Since Class A properties tend to sit in desirable areas, much of your initial due diligence is already done- at least as far as scoping out the area.
Expect these properties to sit in areas with good access to transportation, whether that be in the form of walkable neighborhoods, proximity to job centers, or being close to shopping and retail areas.In addition, when (or if) the time comes to sell- you’ll likely have a much larger pool of buyers looking to acquire the property- many investors ignore B and C properties to focus solely on Class A, either they don’t want the additional risk, or the necessary work to generate potentially higher returns- either way, it makes your life easier when it comes time to sell.
- Class B: The primary benefit to investing in Class B real estate is that these properties tend to be highly durable throughout economic cycles.
In an upmarket, Class B multifamily attracts a diverse pool of renters – both those who could afford Class A real estate but are more cost conscious, as well as those who earn less but are willing to splurge on the amenities included in a Class B property. In a down market, Class A renters will often vacate their units and move into Class B properties as a way of saving money.
Another benefit of Class B real estate is that, if well located, the property can often be brought into Class A condition through thoughtful renovations. Class B properties tend to be between 10-20 years, although this is not a hard and fast rule. Class A properties will typically become Class B properties after a certain period of time, unless consistent renovation and renewal is undertaken at the property- the cycle usually goes Class A to Class B to Class C, although again, this is not set in stone.
These properties are well maintained, with few deferred maintenance issues. Finishings and fixtures on the property tend to be above average, but usually not brand spanking new. They sit in neighborhoods that are mostly middle or working class, with above average school districts and fairly low crime rates. All of these factors add up to a sort of “Goldilocks Effect” where you get many of the benefits of Class A, without the premium price tag
- Class C: The biggest draw of Class C multi family is its price point, as it is the most affordable of the property classes and therefore, appeals to the broadest range of investors.
First and foremost, Class C properties are often available for bargain prices, which can be a godsend in many high cost of living urban areas where prices have grown out of the reach of many investors.
This means investors can acquire more properties with the potential of generating higher cash flow than other classes of apartment building.As Class C properties are usually value-add opportunities, with low acquisition costs and high potential to improve profitability, investors can generate more cash flow from a Class C property than for another property class with higher acquisition, upkeep, and management costs.
Class C properties possess lower acquisition costs means that it can be easier to benefit from the economies of scale with a Class C property portfolio.They often have the potential to benefit from forced appreciation, which is when investors and developers add value to a project to increase cash flow, decrease vacancy, and so increase the total value of a given property. There is usually more room for adding value with a Class C property because, provided the neighborhood can tolerate the upgrade, they can be improved to Class B or even Class A properties, whereas Class A properties typically have relatively little upward potential and are most often purchased strictly for yield.
Since Class C properties have lower acquisition costs than similarly featured buildings in Classes A, and B and operational costs can be higher due to the extra layers of management often required to keep a Class C building stabilized.This can dampen relative returns but overall, Class C properties are less desirable to investors – certainly of little or no interest to institutional investors – so cap rates are generally higher meaning yields to investors are going to be higher.
They have greater potential for improvement in both rental rates and occupancy levels so the opportunity to increase capital gains can be more pronounced than in Class B or Class A where there may be less potential to add value.Someone looking to invest in multi family for the first time might start by investing in Class C. They can improve the property over time, perhaps bringing into Class A or B condition, and then sell the property for a profit – profits that can then be reinvested in a nicer, newer multi family property if the investor so chooses.
