Assessing Property Class and Location Risk

In the last two installments of The Passive Investor, we’ve talked about what a real estate syndication is and how to evaluate sponsors. In this edition, we are going to start talking about physical property. We’ll evaluate strategic considerations regarding property class, location, and specifics that can make for a desirable investment. Ultimately this article is about assessing the risk of your passive real estate investment, solely based on the property’s location and condition.  

Property Classes 

Whether you’re interested in passively investing in multifamily, office, retail, or industrial property, you will require a working knowledge of property classes in order to understand the risk associated with each as an investor. The terms used don’t have black and white definitions, but are used as guides rather, in evaluating the age and physical condition of property. Not always, but many times the condition of a property is tied to its location within a market.

A-Class

A-class properties are typically those built very recently with the most up-to-date floor plans, amenities, and finishes. However, location trumps age when it comes to defining these properties. There are well located A-class properties in downtown, city-center locations that are a century old, but have been maintained meticulously. You will often hear investment properties referred to as “core” or “core-plus” assets. Core assets are trophy properties in prime locations. Think Park Avenue in Manhattan or Michigan Avenue in Chicago. Core-plus may be a very high end property, but in a less central part of town or smaller metro area.  

Institutions have access to cheap and plentiful capital, as well as lower return requirements. Larger A-class properties are usually institutional quality assets. They are viewed as more stable assets, with credit worthy tenants. As such, they carry less risk for investors, but as mentioned come with lower returns.  

B-Class

B-class property is not new construction, but still has solid bones, is well-located, and is typically in high-demand from both renters and investors. These properties may be 10-15 years old, with some dated finishes and mechanical/capital upgrade needs. Properties that fit this description cannot command the same rents as A-class properties. However, with some cosmetic upgrades (think paint, flooring, hardware, lighting) these properties can be brought up to modern finishes, allowing the sponsor to raise rents.  

You will see a lot of syndicated investment opportunities with properties that qualify as “B-class.” The execution risk is relatively low, with less intensive renovation requirements.  

 The term “value-add” is often used to describe investment properties that fit these characteristics. The coming-in investors have an opportunity to literally add value to the property. By updating finishes to today’s standard, prospective renters will find the property more appealing, and more people will want to live there. This demand drives rents higher, which in turn makes the property more valuable.  

We will talk much more about this strategy and how properties are valued in future editions of this publication.  

B-Class property tends to be very stable during times of economic turmoil. During recessions, many A-class renters take a step down in luxury in favor of affordability, causing sponsors to reduce rents to attract tenants, thereby reducing income. Meanwhile many C-class renters may struggle to keep up with payments. B-class has the least volatility of all property classes.  

C-Class

C-class property tends to be 30 years or older. It typically has an element of deferred maintenance, has dated units, and lower rents. Its almost never in the metro’s most desirable area and can have occupancy issues, with an existing tenant base that’s tougher to manage.  

However, where there are problems, there are opportunities. Identifying properties that are in the path of progress, or are the “ugliest house on the block,” in an otherwise solid middle-class area can lead to large investment returns. With this value-add strategy there is more executional risk, therefore a higher risk to your investment. Management is more intensive. Pay attention to location here. If it’s a “C" that can be brought up to a "B” due to the surrounding area, that’s potentially a big win. If it’s a “D,” it may always be a “D.”  

D-Class

D-class property is typically in a very blighted area with an element of crime in the community. Property conditions are often beyond a little deferred maintenance, but rather distressed with higher vacancy. As investments, these properties are not for the faint of heart. I would not recommend passively investing in a property that fits this description. Be sure the investment you are considering is not being marketed as a C-class property in a “B” area, when it’s actually in the center of a crime torn community. Sometimes these properties are marketed as value-add, but really should be categorized as “opportunistic,” with a much higher degree of risk.  

Location

Location is the most important factor in determining what a property’s value is, or what it could be. You can’t change location. An area can change over time, but where a property is located is where it stays. You want to be investing in opportunities that are in areas with strong economies, growing populations, lots of job creation, and demographically favorable trends. We’re going to break down location into macro (the market) and micro (the neighborhood) and the factors that drive investment desirability.  

Macro Considerations 

There are a few questions to address when determining a desirable market to invest in:

1) Is the state government landlord friendly or pro-tenant? In my opinion, the tenant is a customer and should always be treated as such. Every option should be exhausted and every opportunity given to a person to stay in their apartment. However, there are bad actors out there. Additionally, some people just don’t want to be helped. Sometimes tenants can violate terms of leases, not pay rent for prolonged periods, or be disruptive to the other residents of the community.  Sometimes, they just have to go.  In certain states, it can take 6 months of lost rent and jumping through hoops to get a tenant evicted. The lost revenue, along with the cost of turning the unit to make it rent-ready for the next tenant, can cost an investor dearly. You want to be investing in states that have pro-landlord laws, which hold all parties accountable to a lease agreement. A lease is a binding legal contract.  

2) What are the prospects for population and job growth in the market? Take a look at the census data. Has the population of the area been declining or is it a growing area. Many times the answer to that question has to do with jobs. If jobs are being created and employers are making investment in the market, people will move there. If companies are shutting down or relocating to other areas, the population will stagnate or decline. I don’t convey investing in areas with declining populations, as a general rule, although you have to take into account….

3) What’s the supply of inventory in the area? It could be the population is only growing by 1% a year, but there is a severe under-supply of product in the market, i.e. not enough places for people to live. Supply and demand is fundamental to macroeconomics. A lack of adequate supply to meet demand leads to an increase in pricing (rents). 

Micro Considerations

The investment thesis for a specific asset’s location comes down to more hyper-local factors. Here’s the questions you should be asking.  

1) How visible is the property from high traffic areas? If prospective tenants don’t know the property is there, it’s likely going to affect demand from both renters and investors. Curb appeal and visibility matter. This goes back to our original point of location being paramount.  

2) What’s the walkability of the neighborhood and is there a lot of crime? It’s been shown that improving an areas walkability reduces crime. You can find out a lot about an areas safety by visiting sites like city-data.com/crime or neighborhoodscout.com and searching by zip code.  

3) How are the schools? A good school system attracts people to move to an area and is a beacon of a strong community.  

4) Lastly, what are the rents? Study the “comps.” Go to apartments.com and take a look at what properties around are renting for, what amenities they have, and what interior finishes look like. Then compare them to your investment opportunity. Does the sponsor’s pitch deck match your research? Do the pro forma rent projections seem reachable?  

Related to rents, you’ll also want to gather data on the median income of the area, rents as a percent to income, historical rent growth, and average occupancy of apartments in the area. Do your own research, but any sponsor who’s worth investing alongside will have this data handy for you.  

Risk Wrap-Up

As you have probably picked-up on, the condition and location of a property can have a dramatic impact on the risk associated with an investment. A C-class property built in 1970 will most definitely have more execution and investment risk than a 2018 A-class property in an affluent suburb. Investors always need to be compensated for more risk, which comes in the form of higher potential returns.

Don’t forget - return projections are just educated guesses until the property sells and you get your principal back. Going back to our last edition of The Passive Investor, the sponsor really matters! You want to be investing with experienced sponsors with a track record of success in their respective strategy. 

In our next edition we’ll be getting into numbers, highlighting income and cash flow.