Apartment Classifications and Expected Returns

consumption-19150_1280-PDApartment Classifications.  When you are an experienced property investor of multifamily properties, there is an apartment grade that you will be intimately familiar with.  Banks are familiar with it, insurance companies are familiar with it, and all investors that invest money in a multifamily complex should be.  Google the topic and find out more if you want, but here is a summary.

This mainly applies to commercial properties, but neighborhoods can be grouped like this as well.  A single family home in a Section 8 neighborhood, is a class ‘D’ building.

Class ‘A’.  These places are generally 1 to 10 years old.  Caps rates ~6% – 7%.  Purchased for potential appreciation.  They may have amenities such as garages, in-unit washer/dryers, pools, spas, rehearsal gyms, the newest technology, etc.  Typically they are occupied by white collar workers.  This is a typical investment by an institutional buyer.  They command the highest rents.

Class ‘B’.  Generally quality construction, little deferred maintenance.  10 to 20 years old.  Generally a ‘middle of the road” property when it comes to amenities.  Located in a good area.  Typically they are occupied by white and blue collar workers.  Often they are owned by investment groups.  Cap rates are 8% – 9% and they are purchased for cash flow.

Class ‘C’.  Product built within the past 30 years.  Rents below class ‘B’ rents.  Some deferred maintenance.  Caps rates ~10%.  Purchased for cash flow.  They are typically occupied by blue collar workers and even some Section 8 tenants.  They are located in working class neighborhoods.

Class ‘D’.  Over 30 years of age.  Mediocre locations.  Lower rents.  No amenities.  Often dangerous.  Caps rates 12%+.  High level of management required.   Lower side of the market in regards to rents.  Marginal construction.  May generate less income due to higher maintenance and management demands.  Class ‘D properties are suited for experienced investors only.

Often properties become troubled due to the average investor not being familiar with the area, and how to manage properties.  They overpay for it, and expenses eat them alive.

There is often the case the property is a class ‘D’ property, even though it should have been at least a class ‘C’, or even a class ‘B’ property.  The cash flow potential lures many naïve investors, and a class ‘D’ property is purchased for a Class ‘B’ or class ‘A’ price, in terms of cap rate.   It is then managed like a class ‘A’ or ‘B’, and the property fails.

If you find a Class ‘D’ property and you are interested in it, calculate the value using a 12% cap rate, often properties are worth closer to $215K, not $300K.

Often a great investment strategy is turning a class of property into the next higher class by modernizing the property and catching up on maintenance.  Many owners have done this, and can see the level of tenant that a class ‘B’ property can bring in.  Better tenants mean more long-term profitability.

The premium deal is finding a Class C property in a Class B area that you can reposition.  Or a class ‘D’ property in a class ‘C’ neighborhood.  Finding a class ‘D’ apartment, in a class ‘B’ neighborhood is a prime investment opportunity.  You should jump on this with both feet, it could turn out to be your investment of a lifetime, if you focus on the goal of turning it around.  AND, if you purchase it at the right price.  Pay for the cap rate the property is currently, not the potential cap rate.  You need to make mney for yourself, not the seller.

Think about this:  Increasing the cap rate by as little as 2%, could increase your properties value by $110,000 (assuming a 4-plex, renting at $1K per month, per unit and a 45% expense ratio).  This can be done by increasing the classification of the property by just one notch!

Have you ever wondered how apartments are priced? Or any investment properties? Have you ever looked at apartment classifications?

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