Property Class Systems for Real Estate Investors

“A house that one investor considers to be Class A might be a Class B to another investor . . .” (Rhode, Jeff. Everything You Need to Know About Real Estate Property Classes. (July 13, 2021)

Whether you are looking at or the website of a Real Estate Attorney like Lee & Associates, the advice is generally the same: Building Classifications are a flexible guide that are largely subjective.

What does this mean for you as a real estate investor?

I find that property class is not an important metric, and thus it should not mean much to you as you shop for your next deal. However, if property class is important to you, then recognize that it is a subjective metric.

When dealing with a subjective metric, like property class, it is important to follow three step process:

  1. If you have enough familiarity with the area, never trust another person’s assessment of building quality. Try your best. Develop a feeling for the various options in each age range and property type. And, classify for yourself what properties are top of the line (Class A), middle of the road (Class B and C) or dumps needing major overhaul (Class D).
  2. Lean on a local expert you can trust. While a local expert may not have seen the inside of the specific parcel you like, a local expert does have a good idea of what is available on the current market. This experience helps differentiate between what constitutes a good property or a bad property.
  3. If you can’t get information from a trusted local expert, then, and only then, should you put any value in an advertised property class. If you find yourself in this final group, treat the information with caution. As you proceed with the purchase, do everything to verify your expectations.

Each investment expert has his or her own standards. Some similarities exist between them. And, some of the factors have more weight than others.

Building age is likely the #1 criteria that you will see referenced in a property classification scheme. All the things that make a class B fit into class B are nearly impossible to find if the building is brand new. (not impossible, but nearly impossible.)

As a building ages, standards change, and aspects of the building that made it class A back when it was new (15 years ago) are now facing economic or social/aesthetic obscolescence.

Properties under 20-years-old are likely to fall into Class A or B. Properties between 15 years and 40-years are more likely to be Class B or Class C, and Properties older than 30-years are going to likely fall into B, C, or D classifications.

What is more important than the Property Class?

Because Building Classification is such a loose and subjective value, it does not make sense to verify your opinion as compared to the advertised value by a listing agent or seller. What matters more is the facts that you uncover during the investigation process.

  • What are the projected maintenance expenses?
  • Does the condition of the building suggest a reason to increase your anticipated maintenance budgets?
  • Does the condition of the building suggest that you might need immediate repairs (additional upfront cash investments)?
  • With projected cash flows in a current state or a repaired state, does the project make sense?

Remember that Property Class will change from Location to Location

It was 2019 when I took Eddie on a tour of Bakersfield’s residential investment properties. Eddie had successfully invested in Las Vegas with his brother, and this was the first time that he was making a solo investment without his brother’s support or expertise. He was nervous about failing. How would he feel if he bought the “wrong property”?

We saw the first property, and he said, “This is no good. It has a swamp cooler.” (A swamp cooler is sometimes referred to as an “evaporative cooler,” it’s a type of cooling system considered less desirable than air conditioning.)

At the next property, he said, “This is no good. It has a swamp cooler.”

By the third property, he said, “Stop showing me properties with swamp coolers!”

To Eddie, swamp coolers dramatically lowered the property class. Even though Eddie didn’t have this language as part of his vocabulary, he was telling me that the Class B properties that I was showing him appeared to be Class C or D to him.

What Eddie did not know was that, in the price range that we were shopping, and in these Bakersfield neighborhoods, swamp coolers were the standard. The mere fact that a property had a swamp cooler rather than air conditioning did not lower its property class. Bakersfield tenants in those properties didn’t expect air conditioning. And, Landlords never had a reason to install them. The laws of economics dictated that air conditions would not be economically smart for these properties.

Eddie and I saw more properties, and eventually, Eddie adjusted his standards to match the market. Once he better understood the Bakersfield market, he started to reconsider some of the properties and realize that some of them were real gems! As soon as that happened, he put in an offer and closed on his first solo investment property.

Eddie bought two units that year. He returned in 2020 and bought three more; I couldn’t believe it when he called me in 2021, and told me that he was looking to buy again.

When I asked Eddie what changed, he said it all came down to what I said to him on that first day. He had to start looking at the apartments through the eyes of the people who were going to live in them and compare those apartments to the others that were currently available on the market.

“The mistake I made, Jared, was that I was looking at these places and asking myself if I wanted to live in them. I was comparing them to apartments that I’d rent in Los Angeles and not to apartments that I’d rent in Bakersfield.”

That’s the thing about Building Classifications. What differentiates a Class A property from a Class B property, or a Class B property from a Class C property, depends on local trends and subjective opinions. Ultimately, whether you classify a property in one box or another does not impact the value of your investment or your return.

What Class does Jared prefer?

If I’m shopping for myself, I really love Class B and Class C properties; specifically, I like staying in the residential markets. I’d rather have four 4-plexs than a single 16-plex. I want something with age that needs some work. I want the property to be rented low and to have a moderate amount of deferred maintenance. I prefer that these properties be located among other properties of a similar or better class, because I cannot improve a Class D property when it is next door to the property that I own. I can improve a Class C property to make it more like neighboring Class B properties (and substantially improve its value in the process).

Want to learn a little more about real estate investments? Check out the article on CAP rates.

Want to learn a little more about investing in blockchain? Check out my recent article on Non-Fungible Tokens.