We’ve seen an increasing level of interest in Class B and C multifamily assets in recent years.
There are a number of factors influencing these changes, which range from over-construction of luxury Class A apartments in the past five years, falling homeownership rates, and demographic shifts that are causing people to move towards a renter lifestyle either by necessity or lifestyle choice.
Savvy investors, both domestic and international, are aware of these trends and are pouring investment dollars into class B and C multifamily properties as a result. We expect this trend to continue well into the next decade and beyond.
For those of you who are unfamiliar, let’s start with a brief primer on the different classes of real estate.
Remember that these are not hard definitions and everyone you ask will have a slightly different way of defining the classes.
There is no centralized school of thought in real estate, so there are many examples like this within the industry where everyone is kind of working off their own “pet definition” of a phrase.
This was something that confused me way back when, so hopefully putting that out there helps someone.
Class A Properties:
These are the highest tier of quality level for multifamily apartments. Class A properties were typically built within the past ten years.
They achieve the highest rental rates of any of the classes and are usually centrally located with easy access to amenities like fine dining and retail.
Newer class A properties are also often transit-oriented developments in strategic locations that make commuting either by car or public transportation effortless for the residents.
Class A properties will be the talk of the town as they are the newer, most desirable type of property to live in.
That said, the majority of renters do not inhabit class A buildings.
The tenants in these buildings are in most cases capable of homeownership, but remain renters as a lifestyle choice rather than due to necessity.
Class B Properties:
This is the next step down below class A, but it’s the second best option out there, so these are still pretty nice apartments.
The tenant base is usually both white collar and blue collar.
These properties usually aren’t as centrally located as a class A property, but are usually on the outskirts of amenity-laden areas and are practical and convenient for commuters.
Think of those neighborhoods that are desirable, despite maybe not being the absolute best in the area.
In towns experiencing population growth or gentrification, class B properties can be transformed into class A properties with strategic renovations.
A property that classifies as class B should be in good working order with no impending major expenses on the horizon.
Class C Properties:
These properties are located in working class communities and the tenants are typically renters by necessity because they can’t afford to purchase a home.
These areas are less desirable and cannot attract the same rents are class A or B properties, but they are typically the best properties for cash flow and can be particularly attractive when purchased in a densely settled area undergoing population growth.
Class C properties provide a natural form of affordable housing for the working class backbone of our economy.
The buildings themselves usually have some deferred maintenance and will need some capital allocated to repairs and improvements.
This does not imply these are run-down buildings, on the contrary, some class C buildings we have purchased have extremely solid construction (speaking as a developer).
It’s just likely that some of the major systems will need to be replaced (for example, a new roof, windows, or boiler).
For a more in-depth discussion of the classes of multifamily assets, please check out our Class A, B, C, and D Multifamily Classes Explained article for additional information.
The Demographic Shifts
We’re contending with several factors that are coalescing to drastically decrease the homeownership rate by the year 2050.
For better or worse, even the most optimistic projections are showing a drastic reduction in homeownership by the year 2050.
We are already along for the ride as we increasingly become a renter nation.
There are a variety of reasons for this, but two of the largest factors are crippling rates of student loan debt and a trend towards marrying later in life.
Working in tandem to reduce the rate of homeownership, these factors leave young people with a lower household income and higher monthly expenses than the generations that preceded them.
There may also be a generational trauma towards homeownership following the great recession.
According to a survey conducted by Eventbrite, 78% of millenials prefer putting their money towards temporary experiences, rather than long term purchases like a home or a car.
Whether or not that’s a wise life philosophy is up to you, but you can imagine that this has affected the desirability of owning your own home.
Couple this with a construction shortage that has barely been able to keep pace with demand, and prices for new homes have and continue to surge across the country and you’ve got some severe pressures towards remaining a renter on a large swath of the nation’s population.
The period between the ages of twenty and thirty four is considered to be the time that one is most likely to be a renter.
That segment of the population is projected to swell to over seventy million people within the next five years.
You can bet this will make big waves in the market and those investors that position themselves properly will benefit.
We have a bit of a mismatch between the new construction inventory that has been frenzily built in recent years as opposed to the actual demand from the new renter households that are entering the market.
Due to the high cost of construction, developers have been leaning heavily towards highly luxury class A projects. These types of properties may do well in strong economic times, but they are far more vulnerable during a downturn. Just take a look at what happened to Class A assets during the dog days of the COVID-19 pandemic:
As you can see from this graph, Class B and C properties (which would fall under the 1-3 star categories) had continued rent growth even during the pandemic, whereas class A properties experienced a significant dip in their rental rates.
This demonstrates the recession-resistant nature of class B and C multifamily. Even if a class A asset is the most beautiful building on the block and has impressive rents on paper, it won’t amount to much when vacancies spike in uncertain times.
This can quickly cut your NOI deeply – you won’t feel much solace from your top-of-the-market rents when you’re hemorrhaging money due to low occupancy levels. In spite of this, prices for class A assets remain sky high with very low cap rates in the major markets across the United States.
Class B and C properties are attractive to a more universal demographic than the luxury class A properties that developers have been churning out in the past decade.
They will usually house a combination of people that are renters by necessity and renters by choice.
You’re also likely to see tenants from all of the living generations, with the aforementioned millenials being major players, but also members of the baby boomer generation whose children are grown and are looking for a more appropriate home for their next chapter in life.
While the definitions vary depending on who you ask, class B and C properties were usually either newly constructed or substantially renovated within the past fifteen to thirty years.
They are typically located within middle-class neighborhoods that are safe to live in and have a variety of residents, from young families to retirees.
Due to the competitive pricing when compared to class A properties, people from all walks of life are driven towards class B and C properties because of their affordability. In a recessionary environment, you’ll also acquire tenants that would normally go for class A assets.
The value-add investment strategy, where real estate investment companies like Winterspring Capital acquire assets that need some rehabilitation work, is most suited for class B and C properties.
This strategy provides the highest return to investors with minimal added risk. It essentially involves a “slow” renovation where you take an already occupied building and improve it over the course of two-three years. As you renovate units and make improvements, you raise the rents to the market level as new tenants come in.
This strategy is obviously infeasible for a Class A property. Due to these properties being newer and already desirable, there is little room for improvement, so they are more appropriate for institutional investors comfortable with a lower yield than real estate syndication companies like ourselves.
If you tried renovating the kitchens and bathrooms at a class A building, people will look at you funny and wonder if you need psychological assistance.
If you do the same thing for a class B building, you’ll be attracting new tenants willing to pay a higher rental rate, rather than psychologists concerned with your mental well-being.
We look for class B and C properties that are not being managed responsibly by their current owners and have a lot of “meat on the bone” for growth potential. This can significantly boost your property’s net operating income and value on the open market, yet the renovations themselves are cheap by comparison to the value you can create.
Conclusion
There are many different ways to invest in multifamily real estate, but the safest bet in our opinion is with B and C class properties. These are the properties that can be most positively affected by the actions of a skilled operator, while still retaining minimal amounts of risk due to the extremely high demand for this type of housing product and a nationwide supply shortage.
