In Part B of our commercial real estate types and categories article, we are discussing classification grades, which are assigned to commercial properties.
If you didn’t read Part A, read it here.
Commercial real estate is generally classified into one of three categories: Class A, Class B, or Class C.
What The Letter Classifications Mean
Letter grades are assigned to properties after considering a combination of factors such as age of the property, location of the property, tenant income levels, growth prospects, appreciation, amenities, and rental income.
Building classification allows a user (or potential user) to differentiate buildings and rationalize the market data.
The classification standards do vary by market, and each category is defined in relation to its counterparts. Because of this variation, there is no precise formula by which properties are placed into classes. Below is a breakdown of the most common classes for commercial real estate properties.
Types & Categories of Commercial Real Estate
Class A Properties
Class A properties represent the highest quality buildings in their market and area. They are generally newer properties built within the last 15 years with top amenities, high-income earning tenants, and low vacancy rates. These buildings are outfitted with top of the line fixtures, amenities, HVAC systems, and the latest technological gadgets.
These buildings are well located in the market and are typically professionally managed. The properties are aesthetically attractive and managed, and are commonly present in high-visibility or trafficked areas. Additionally, they typically demand the highest rent with little or no deferred maintenance issues.
For investors looking for capital preservation, Class A may be the right investment. Class A provides investors with more security by knowing that they are investing in top-tier properties, with little or no outstanding issues requiring further capital expenditures.
Class B Properties
Class B properties are generally a bit older than Class A properties, tend to have lower income tenants, and may or may not be professionally managed. The spaces can be described as “average” and the high-end fixtures, and features of Class A properties are absent.
Rental income is typically lower than Class A properties, commanding “average” market rent, along with some deferred maintenance issues. Class B buildings are typically less than four stories tall and are either found in the suburbs, or at the outskirts of large districts.
Mostly, these buildings are well maintained and many investors see these as “value add” investment opportunities because through renovation and common area improvements, the property can be upgraded to a Class A property.
Buyers are generally able to acquire these properties at a higher cap rate than a comparable Class A property because these properties are viewed as “riskier” than Class A properties.
Class C Properties
Class C properties are typically more than 20 years old and are located in less than desirable locations. The property is generally in need of renovations, including updating the building infrastructure to bring it up-to-date.
As a result, Class C properties tend to have the lowest rental rates in the market when compared to Class A or Class B properties.
Many Class C properties need significant overhauls to secure steady cash flows that will appeal to investors. With improvements and repairs, a class C building can be upgraded to Class B.
These properties, along with some in Class B, tend to be purchased and sold at higher cap rates than in Class A as investors are paid for the additional risk of an older property with lower income tenants, or a property in a lower income neighborhood.
For investors looking for capital appreciation, Classes B and C are better investments for that specific risk profile. There are more opportunities to increase income potential, or value of the property, once renovations and repairs take place.
For investors seeking capital preservation and less risk or management, Class A is the investment to consider.
