I’ve discussed, in previous articles, the explosion in the Class A/trophy multi-family market and how unsound investment principles may contribute to a correction in the years to come, but in this case I will be discussing Class B and C assets. While a specifically defined and universally agreed upon set of criteria does not exist, Class B and C properties are generally older and, as a result, do not have many of the amenities offered by new, Class A apartments. They may also be less efficient from an operational standpoint due to the age of building systems and, thus, are able to achieve a lower NOI compared to the gross revenue they generate. Rents are more affordable in Class B and C properties; making them available to a greater number of potential renters. In this article, I will go through the defining characteristics of Class B and C properties and explain how these create unique investment opportunities that mitigate many of the risks faced by their Class A counterparts.
Because age is one of the defining characteristics of Class B and C multi-family properties, one of the benefits to these investment assets is that they already exist. You don’t have to build them and thus incur the costs associated with development, which is a combination of time, permits, construction costs, and vacancy. When an investor purchases an existing property they are purchasing something with inherent value (cost to build) and with the ability to generate income through rents. There are historical records of rental rates, operating expenses, etc. The buyer has access to data and understands what they’re buying. If they can buy the asset for the right price, they should have an asset that will cash flow indefinitely. It may be sexier to own a Class A apartment building, but what they lack in sex appeal, Class B and C assets make up for in consistency and security.
Lower rental rates are another appealing factor of Class B and C multi-family properties; not because generating less gross revenue is a good thing, but because it opens up the tenant base to a greater number of renters. Vacancy is a matter of choice. You can be 100% vacant if you want to charge $100,000/month for a 1-bedroom apartment or 0% vacant if you want to charge $100/month. More people can afford $1,200/month than $1,500/month. Interestingly, because more people can afford $1,200/month there is more competition which can lead to more sustainable, if moderate, annual increases versus rates that are already at a stretch for many renters. The difference in revenue between Class A and B options decreases when Class A landlords are having to offer a month of free rent per year (concessions) to attract tenants.
For Class C apartments that are considered “workforce” housing or that choose to participate in subsidized housing programs such as Section 8, landlords are essentially guaranteed tenants. Many blue-collar workers may not have the financial wherewithal to purchase a home but can make excellent tenants. Government programs guarantee or subsidize rents for low income individuals and, while the programs impose specific requirements on the landlord, they can be a consistent way of ensuring an investment’s performance while an area undergoes revitalization/gentrification.
Functional obsolescence is both a risk and opportunity associated with Class B and C multi-family properties. Simply due to age, these buildings may have outdated finishes, layouts, etc. The building systems may be old and less efficient; resulting in higher operating expenses and/or deferred maintenance. While considered a risk, it is this attribute of Class B and C properties that make them so appealing to investors.
Perhaps the most common trend in multi-family investment is the renovation and repositioning of these types of assets. The basic formula is to buy a Class B or C apartment building, renovate the units (and sometimes building systems), and raise the rents. The higher rents (hopefully coupled with reduced operating expenses) leads to increased NOI. Furthermore, because the new owner has improved the property they have also increased the desirability from a leasing standpoint and eliminated future costs/risk associated with deferred maintenance and renovations which decreases the market cap rate (increases the market value).
Here is an example to better explain these concepts. An investor purchases a 20-year old, 100-unit apartment building for $8,000,000 ($80,000/unit) at a 7.5% cap rate. The units rent for $1,000/month and operating expenses run about 50% of gross revenue, so that NOI equals $600,000/year. The new owner purchases the property with a plan to renovate the bathrooms and kitchens of each unit at $20,000/unit and spend $100,000 updating some of the building systems to increase the building’s efficiency. The result is that the owner is able to increase the rent to $1,200/month, lower operating expenses to 40% of the gross revenue, and sell the property the following year at a 6.5% cap rate. So, how much does the owner make?
Due to the increased rents and greater efficiency the owner was able to increase the NOI to $864,000 and by increasing the marketability/reducing the risk of the property and selling at a 6.5% cap rate the property is able to yield a sales price of $13,292,307.69 ($132,923.08/unit). Even after subtracting the costs of upgrading the units ($2,000,000) and building systems ($100,000) the owner nets $3,192,307.69 ($11,192,307.69 – $8,000,000). That’s a significant amount of money, and while this is a simplified and hypothetical example, it shows the opportunity presented by Class B and C multi-family assets.
Class B and C multi-family properties are subject to the same risks as other real estate investments. The old adage that “you make your money in real estate when you buy the property” is true, but unlike their Class A counterparts, these asset classes present an opportunity to increase return by adding value.