Summary: In this article, learn about the classes of property in real estate and the difference between A, B, C and D neighborhoods. Topics also include factors that impact property class, what to expect when buying in these neighborhoods and which property class is the best investment.
Introduction
One of the most difficult questions real estate investors ask themselves is, “where to buy real estate?” That’s when understanding classes of property in real estate comes in handy. In the real estate industry, properties and neighborhoods are both generally rated as, “A”, “B”, “C” or “D”. As such, a C-rated neighborhood will quickly tell the experienced investor a lot about the potential investment. This rating should give investors a glimpse of what kind of tenants the property could attract, how much rental income to expect and the level of risk associated with that particular investment.
Keep in mind that real estate asset classes aren’t definitive. There may be investors that look to buy “D” properties in “B” neighborhoods and renovate or rebuild to the neighborhood standard. On the other hand, investors may choose to buy or build an “A” class property in a “C” rated neighborhood. Whether you are investing for cash flow, appreciation or a little bit of both, each scenario can look a bit differently. Which is another reason performing extensive due diligence is so important.
What are Classes of Property in Real Estate
Real estate property classes are determined by a variety of factors, including location, age and overall condition of the property (and it’s important to consider each of them during your estate due diligence process). Just like you get a grade in school, real estate properties and neighborhoods earn a grade too. Each property is given a grade, A, B, C, & D, based on four general factors, 1) the property, 2) the affordability, 3) the amenities and, 4) the livability.
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The property itself is evaluated and classified based on its age and overall condition. Affordability is basically how much the investor can afford or wants to invest. This decision should be based on potential rental income of a property and rental demand.
Amenities are really where neighborhood classes come into play. Is the property located close to great stores, parks, schools and jobs? These factors will impact the property’s grade for better or worse.
And finally, livability refers to crime rates, the number of owner-occupied homes versus rentals and quality of tenants. Each of these factors should be researched, analyzed and given an overall grade to measure an investments level of risk versus reward. Although, for this report card, investors may not be looking for straight A’s.
What is a Class A Neighborhood?
The first real estate property class is “A.” a class A neighborhood, you’ll typically find professionals, like lawyers, doctors and executives. Houses and yards are usually well-kept and the streets bustling with children playing.
The Property
Properties located in “A” neighborhoods are typically newer, likely built in the last few years. They could have luxury finishes, upgrades, outdoor space and a garage. One thing for investors to note is that maintenance and Capital Expenditures on these properties is extremely minimal.
Affordability
Because properties in “A” neighborhoods are usually more pricey, some investors will avoid them because they tend not produce as much cash flow. However, higher property values usually mean higher rents so big investors who can afford it, may choose to buy in these areas. Remember, it’s wise to only invest in an A-grade neighborhood if there’s a high chance the area is going to increase in value or appreciate substantially in the future. Investors counting on future appreciation are almost always putting themselves at more risk.
Amenities
A property’s value increases when it’s in close proximity to attractive amenities. “A” class neighborhoods might have a Starbucks, Trader Joe’s and shopping mall nearby. There’s also likely access to parks, open spaces and great schools.
Livability
These neighborhoods have low crime rates and almost all of the houses are owner-occupied. Which means, especially for single family homeowners, there’s a greater sense of pride to take care of their home and neighborhood.
Why Invest in an A Class Neighborhood
Home prices are usually more expensive in A class neighborhoods, which means rental properties don’t cash-flow very well. Investors generally invest in A class properties when they think the area is going to appreciate significantly. However, this can be riskier, because there is never a guarantee of appreciation.
What is a Class B Neighborhood?
In general, “B” neighborhoods are home to working class people, like teachers, firefighters, and nurses.Many investors believe that investing in B real estate property classes is the safest option. Continue reading to learn more.
The Property
Class “B” properties are normally less than 20 years old (remember, there are always exceptions) and build with mid-grade or average-quality finishes. Because these properties are a bit older, expect to spend more money on maintenance and Capital Expenditures as things start to wear out.
Affordability
By and large, rentals located in “B” neighborhoods experience the lowest vacancy rates. These properties are more affordable for investors, come with relatively high rents and oftentimes attract longer-term tenants with young families. Single-family rentals tend to endure less abuse than multi-family (i.e. apartments) because tenants consider it more like a home than a rental.
Amenities
Proximity to local amenities, jobs and good schools is commonplace in these neighborhoods.
Livability
On the whole, the crime rate in “B” grade neighborhoods is low. The number of homes occupied by owners still far outweighs the number of rental properties. But there will be some more options for renters than in “A” neighborhoods.
Why Invest in an B Class Neighborhood
B class neighborhoods are more affordable than A class and rental properties generally experience much lower vacancy rates. These means that in a “B” real estate property class there is often a stronger opportunity for cash flow. However, there’s never a guarantee.
What is a Class C Neighborhood?
The general population living in “C” neighborhoods is mainly labor workers–service industry, hospitality, construction, etc.
The Property
A property’s age in class “C” neighborhoods can vary greatly. With these types of properties, it’s even more important to perform extensive due diligence. Maintenance and repair costs will generally be much higher than “B” properties. Additionally, it may need structural and mechanical repairs and/or a new roof.
Affordability
Rents for “C” rated properties fall in the mid-to-low range and attract below-average income earners, in general. These types of properties are much more affordable to the majority of investors and show good cash flow–at least on paper. More on that later…
Amenities
There may be some access to good amenities, but chances are they’re not very closeby. In class “C” neighborhoods, you may see discount grocery stores, thrift shops and average to below average schools.
Livability
Class “C” neighborhoods routinely have more crime, though typically non-violent. There’s a split between renters and homeowners in these areas. Pockets of only rentals can cause neighborhoods to deteriorate more quickly. The majority of people looking to rent in “C” areas make below-average income and stay for less time.
Why Invest in an C Class Neighborhood
Properties in C class neighborhoods often cash-flow well on paper because the prices of the houses are low relative to rents. However, these neighborhoods tend to attract lower quality tenants and properties may need more maintenance. That said, it is possible to generate strong monthly cash flow in these neighborhoods. But again, of course there is never a guarantee.
What is a Class D Neighborhood?
The Property
I would describe class “D” neighborhoods as basically a warzone. Neighborhoods and houses are older, dilapidated and in disrepair. You’ll find vacant, boarded up buildings, graffiti, vandalism, more drug activity
Affordability
Properties in these areas are very affordable and cash flow well on paper, but the cost of repairs and expenses makes “D” neighborhoods a poor place to invest.
Amenities
Almost no access to good amenities, jobs and schools.
Livability
Crime is high in class “D” neighborhoods. The number of renters far outweighs homeowners leaving very little pride of ownership in the area. This almost always results in rundown neighborhoods and houses.
A great resource for tons of information on neighborhoods and schools is niche.com. On this website, you can search by school or school district to find an overall niche grade or rating. The niche grade includes a full “report card” of other relevant categories like, Academics, Diversity, Teachers, College Prep, Clubs and Activities, Health and Safety, Administration, Sports, Resources and Facilities and even food. These are important factors to take into consideration when choosing where to buy rental properties.
Why Invest in an D Class Neighborhood
Eh… we generally wouldn’t recommend it. That said, there are potentially some good opportunities to be found in certain D class neighborhoods. Just make sure to do extensive due diligence before investing!
The Gap Between Class B and Class C Neighborhoods
While there may not be a huge difference between a B and a C in school, the same doesn’t apply to neighborhoods.When it comes to classes of property in real estate, it’s essential to be able to differentiate between B and C neighborhoods.
Property Value
A property’s value goes up or down based on the state of the houses surrounding it. Because homeowners have pride of ownership, they tend to take better care of their houses and yards. If you buy in a predominantly tenant populated neighborhood (i.e. class “C”), your property may not appreciate or even lose value.
Once again, a “C” rated property may cash flow well on paper, but realistically, both the property and tenants will usually have higher maintenance costs. Additionally, property management fees (often 10%) will often be a lot higher on “C” properties.
Tenant Quality
A class “C” neighborhood will usually attract “C” quality tenants and neighbors. Landlords may go to great lengths to keep the property well maintained and attract good tenants, but if the guy next door is a noisy slumlord it will be hard to keep good tenants. Typically, higher rated neighborhoods will attract higher rated tenants.
Exit Strategy
Buying an investment property in a predominantly owner-occupied neighborhood gives you a couple exit strategies. You can sell the property to another investor or homebuyer. Investors may be able to get more money selling to a homebuyer that will actually be living in the home because it’s a more emotional decision. Whereas investors are looking strictly at the numbers.
If your property is located in a predominantly tenant-occupied neighborhood (“C” class), the only likely exit strategy is to sell to another investor.
What Property Class is the Best Investment?
Every investor and investment opportunity is unique so it’s difficult to say what property class is the best to invest in. Better questions to ask might be, which class of property do I want in my investment portfolio? And what is your investment goal?
Investor Rule of Thumb:
A = Appreciation
C= Cash flow
B= A little bit of Both. For most investors, “B” is the sweet spot.
Buying in class “B” neighborhoods is a popular option for investors who can afford it. These properties usually come with less maintenance, fewer repairs and higher quality tenants. These types of properties also tend to produce the best cash flow.
Conclusion
Understanding the classes of property in real estate is an important and helpful tool for investors. The characteristics of A, B, C, and D neighborhoods can vary significantly and will most certainly impact the success of your investment property. Choosing a good neighborhood can sometimes be even more important than choosing a good house. After all, nobody wants to live next to a house with overgrown weeds and piles of junk.
