In the real estate rental business, as every business, it is best to network and work with as many people as you can. By networking with others who are in the same business as you, you can work together to find properties, come up with creative ideas, or even partner on deals.
I have been networking with O’brian, or OB for short, for a while now. He is a fellow investor who invests out of state too. Like myself, he realized that rental properties were the best investment AND that it is possible to invest in another state that you do not live in. This is why I wanted to invite OB from www.outofstateinvestor.com to make a guest post on a topic that has helped his business. So, here he is with some insight into what types of properties you are going to run into as you build your real estate business.
School’s back in session and pretty soon parents will receive progress reports filled with hopefully A’s and B’s. Nowadays, a lot of grades are electronic. When I was a kid, we received triplicate forms that were hand written.
Although I never altered my grades, I once had a “friend” who carefully turned his C- into a B+.
On the surface it looked like he was doing well in class. His parents were duped and didn’t even realize their kid was actually struggling. The parents could have helped more had they known their child was actually just barely above a D.
So what happened with my friend?
He ended the semester with a D. His parents then grounded him. He’s now financially free.
Whether one gets A’s or D’s, I would argue it doesn’t predict one’s financial success.
Likewise, rental property is often described in this way. You have your A’s, B’s, C’s, and D’s. Unlike in school where everyone is shooting for an A, real estate investors all have their own preference. Many shoot for B’s and C’s, while some even target D’s!
In this post, I’ll explain what rental property classes mean, their general trends, and what to watch out for when someone is selling you a specific property class.
Property Classes Defined
Calling a property Class A, B, C, or whatever is pretty subjective. While one investor may call a property Class C another investor or Turnkey provider may label the same property as Class B.
Here are some characteristics (condition, location, and tenant class) that describe each property class.
Class A properties tend to be new construction or built within the last 5 to 10 years. However, old historic homes that have been fully remodeled can still fall within this category. The amenities are top of the line and often new. We’re talking stainless steel appliances, granite counter tops, crown molding, hardwood floors, and the like.
Class A properties are located in the most desirable areas with the highest potential for appreciation. The great location and condition of these homes will not only keep vacancies low, but they also attract the highest quality tenants. These are high income earning professionals or white collar workers including doctors, lawyers, and business owners. On the downside, Class A properties come at the highest purchase price. So the investor’s initial cash flow tend to be the lowest when compared to Class B or lower properties.
Class B properties tend to be a littler older than Class A properties. Usually between 10 and 30 years old and so Class B properties will result in a bit more maintenance to maintain them. Properties may still have some great amenities such as hardwoods, but it isn’t always required. Located in stable, good communities with good schools and the potential for appreciation. The tenant class can be a mix of professionals and higher earning blue collar workers. While the rents are not as high as Class A properties, the acquisition costs are much lower. So overall, cash flow is acceptable with potential appreciation.
Class C properties tend to be old properties, built 30+ years ago. Most suffer from quite a bit of deferred maintenance. They are located in older or even declining neighborhoods where there’s a large mix of renters and homeowners. While crime is not found everywhere, it can be more apparent here and the local schools are not that great either. Appreciation potential is very low or not to be expected.
The tenant class is blue collar and earning an hourly wage. Finding qualified tenants will be tougher and may contribute to longer vacancies. Management will be more intensive than with Class A or B properties so expect higher maintenance, higher turnovers, and higher likelihood of evictions. On the plus side, investors can purchase Class C properties for cheap that rent for greater than 1% of their acquisition cost. So cash flow can be quite high with these rentals.
Class D properties are old, run-down, and often in need of significant repairs. They are located in declining communities that are dangerous with high crime and poor schools. Some investors describe it as a “war zone”. The tenants here are very low income, have bad credit, and many have a criminal background. From a management perspective, these tenants are the most challenging to work with and the most time-consuming when it comes to collecting rent. While evictions are to be expected, don’t expect any appreciation on your Class D property. These properties are the absolute cheapest to acquire and have the highest rent-to-price ratios on paper. So in theory, Class D properties can have the highest cash-on-cash returns.
Property Class Trends
I’m a visual learner so let’s see if we can graphically depict the major relationship of various property classes. As you can tell, the following are not to scale or scientific in any way, but it illustrates key relationships that you should be aware of.
Price and Returns (Cap Rate)
Price is what you pay for a property. Class A properties come at the highest price and Class D come at the cheapest. As you go up in property class from D to A, the price will increasingly rise.
Rental income also follows a similar trend. Class A properties will rent more than Class B properties, which in turn rents more than Class C properties. But, there’s one big distinction. The drop in rent as you go from Class A down to Class D is less than the drop in price.
Let me repeat this because this is key.
Home prices drop much more than the drop in rent when going from Class A to Class D.
For example: a $300,000 Class A home may rent for $2500 a month, a $150,000 Class B property rents for $1500, a $75,000 Class C home may rent for $1000, and a $30,000 Class D home may still rent for $750. Notice that the price drops significantly when dropping in class, but the rent does not reduce in the same proportion. In going from Class A to B, the price is reduced by 50%, but the rent only drops by 40%. In going from B to C, the price reduces again by 50%, but the rent drops by only 33%.
So what’s the bottom line?
Investors will get a higher rent-to-price ratio as they go down in property class. This ultimately translates into higher capitalization rates and higher returns.
So a Class A property will come at the highest price, lowest rent-to-price ratio, and therefore generally have the lowest cap rates. On the flip side, Class D properties come at the lowest price, highest rent-to-price ratio, and therefore come with the highest cap rates.
Appreciation (Location) and Risk
When looking at the previous chart, you may wonder why an investor would ever buy Class A properties with their high price point and low returns. So now let’s talk about risk and appreciation.
Much like the first chart, risk and appreciation also follow an inverse relationship. The potential for appreciation increases as you go up in property class. So Class A properties tend to have the greatest potential for appreciation, whereas the lower the property class, the less likely appreciation will materialize.
On the other hand, risk tends to increase with lower property classes. So Class A properties are viewed as the least risky investments with the highest appreciation potential. Class D properties are typically the most risky investments with the least appreciation potential. Risk can be in the form of dealing with evictions and vacancies will go up as you go towards Class D properties.
Also following the risk curve is the level of management required to operate the property. The lower the property class, the lower the quality of the tenants so property management will be more intensive. Class A properties tend to run themselves, whereas Class D properties will require greater oversight to collect rents, perform maintenance, and deal with tenant problems.
The Problem with Property Class Labels
The biggest problem with using property class labels is that many will use their own definition! Some label a property exclusively based on the rankings of its nearby schools. Others pay less attention to a property’s location, but instead rely on the house’s condition or age. When there’s no universally accepted standard for property classes, there’s bound to be confusion!
Despite there not being a universally accepted definition, there’s less disagreement when dealing with either the best (Class A) or the worst (Class D) properties. Most won’t argue with you if you labeled a property Class D because it’s in a war zone even if it was built in the last 10 years.
The trouble is with labeling those middle B and C class properties — some even use pluses or minuses to get even more specific.
Don’t Be Fooled by the Seller
So what’s the big deal if someone calls a property Class B instead of Class C?
Well, it depends on who’s doing the talking.
Here’s 2 scenarios:
- You’re at a networking event and meet a buy and hold investor. They describe their portfolio as a collection of Class B properties.
- You’re looking to buy a rental property. A turnkey operator emails you about property they have for sale that is described as Class B.
Which scenario do you need to understand their meaning of Class B?
That’s right. Scenario #2.
In the first scenario, you may not be on the same page as the other investor, but it doesn’t really matter. You’re not buying their properties. For all you know, the properties may not even exist!
In the second scenario, you are a potential buyer. So you must understand that you’re being pitched a rosier picture than the reality. The seller in this case is a turnkey company and has an incentive to sell you at the highest price possible.
A Class B property is going to sell for more than a class C property because it is perceived to have higher value. Keep in mind that a property on the borderline between class B or C will likely be pitched as Class B so that it can be sold for more.
Example — A Real Turnkey Property
So if we can’t trust what property class a seller or turnkey company tells us, then what do we do?
First off, don’t let the seller’s Class B or C description set your first impression of the property.
We need to stay objective and stick to the facts.
Using the property address, we can determine whether a property is in a good location and fits the type of investment we are looking for. As an investor, if you’re looking for a class B property then make sure that what a turnkey company sends you is in fact Class B.
This year I received an email from a turnkey operator that was marketing a Class B+ property for sale. Here’s the actual address that you can even look up:
7602 E 48th St, Lawrence, IN 46226
Class B+ For Sale — Is the Turnkey Full of It?
From the get-go, you may already have a preconceived notion about this property. The turnkey company says it’s B+. Rather than take their word, let’s instead do some research.
Here’s what we can find based on the address.
- Property is built in 1957, so it’s nearly 60 years old!
- The nearest school has a Great Schools rating of a 5 out of 10.
- Zillow estimates the property value at about $75k compared to the city’s median home price of about $127k.
- Median household income of the property’s zipcode is only $33k compared to the city’s median household income of about $50k.
- Based on a Trulia crime heat map, the property is in a safe neighborhood.
Sticking to the Facts
Right off the bat, this property is old and has average schools. I would consider a Great Schools ranking of a 5 as just okay. It’s not good, but it’s also not terrible.
The property value is estimated to be far under the median value of all homes in that city. Half of all homes in the city are valued at less than $127k, whereas this turnkey property is valued at only $75k. Based on this, we know that the property is significantly cheaper than most properties in the city.
Further, the median household income within the turnkey property’s zipcode is almost $20k less then the median household income of the entire city. So the people living in this area of the property not only live in cheaper houses, but they also earn far less than more than half of the people in this city.
Hopefully, you’re coming to the realization that this property sounds nothing like the B+ property it was being advertised as. There was no indication of it being in a dangerous area so I would probably not classify it as a D.
Though it clearly is a very old property, which means it will typically have more maintenance than a newer house. It’s also located in a neighborhood where both household incomes and property values are very low relative to the rest of the city. If buying this property as a rental, that means the tenant class will also likely be of low income.
Ultimately, if I had to pick a class, I would argue that this property is a C. If we’re really splitting hairs, I’d even describe it as a low C.
Properties are often described on a class scale. You’ve got A’s, B’s, C’s, and D’s.
Generally, you pay more as you go up in property class, but receive lower returns. Buy and hold investors who prefer higher class properties tend to accept lower returns because they are seeking a less risky investment, less management, and more potential upside from appreciation.
If you’re looking to purchase a rental property, beware of how the seller describes the property. Whether the seller is a turnkey company or even a wholesaler, their goal is to make as much profit as possible. So if they’re marketing it as a Class B property, it may actually be a Class C. Even scarier, that Class C property they’re pitching may even be a Class D property in a war zone!
Don’t be duped.
Stick to the facts and come to your own conclusion on the property. If the property checks out and fits the type that you’re looking for, then move forward. If not, keep looking.
What do you think of OB’s post? Leave a comment below.