342: Are Class C Properties a Smart Buy for Today?

SHOW NOTES FOR EPISODE 342: ARE CLASS C PROPERTIES A SMART BUY FOR TODAY?

Class C properties are attracting a wide demographic of investors.  However, is a Class C property a good real estate investment?  There is a lot of information out there about investing in Class C properties, some of which are quite misleading.  In this podcast, before we find the truth, Bill explores the good, bad and ugly of this popular property class.

Introduction

When I started investing in rental properties, my first three properties (2 single family homes and one duplex) were all Class C properties.  Having nearly 5 years experience with Class C properties, I have some strong opinions but I also want to now look at this class in light of current economic times and how the economy may affect these properties.

There are many types of real estate properties available to investors. That’s why it’s important for you to understand the different property classes so as to make an investment in the right property type that suits your investment strategy and goals.  Property classification represents different levels of risk and potential return.  Property classes refer to a property classification system used to determine the potential of an investment property based on a combination of geographic, demographic, and physical characteristics.  It is important to note that the difference in each property class is relative to the market it is in.  Each class represents a different level of return and risk. This classification system is an important factor for real estate investors to consider when searching for the best investment properties. Therefore, as a real estate investor, it is critical to have a good understanding of the characteristics of each of the different classes of property.

Here are the different property classes and their characteristics.

Class A Property

These investment properties are typically newly built (often less than 10 years old) or are historical homes that are fully renovated.  They are usually in good condition and have fewer maintenance issues. This makes them ideal as buy-and-hold investments.

The A Class building usually has modern amenities and high-end finishes such as hardwood floors, stainless steel appliances, and granite countertops.  Since these properties are usually of high quality, they typically come at a higher purchase price compared to other real estate property classes.  This equates to lower cash flow.  For beginner real estate investors with more limited funds, this can be a huge downside.

These types of real estate are typically located in areas that are outside of cities. These areas usually have a high percentage of owner-occupied properties.  Since they have directly invested in the area, owner-occupants often tend to take good care of their homes and neighborhoods.  These neighborhoods will usually have high income, good infrastructure, good school districts, shopping centers, medical facilities, and low crime rates.  These factors increase the demand for this type of real estate as they are really in the best locations.  Therefore, vacancy rates are often low and rental rates are high.  Higher demand also means that investment properties in this class are easier to sell.

Class A properties are generally low-risk assets. They offer security to real estate investors that want investment properties with fewer issues and fewer expenses. And because of their high-quality condition, investors and property owners will find that vacancies are often low.

Class B Property

These investment properties are quite similar to Class A properties but a bit older (often 10 to 30 years) and are of lower quality.  They are generally still in good condition, located in good neighborhoods, and may have features similar to Class A properties.  However, they will often require more maintenance than a Class A property.  As a result, the acquisition costs are relatively much less.  Property buyers can purchase these houses at a higher Cap Rate than similar investment properties in Class A since they are riskier.  The properties are mostly investor-owned and are rented out.

Class B properties tend to have lower-income tenants and the rental income is slightly lower than Class A.  However, they are quite desirable to a variety of real estate investors since they offer more growth potential.  Through some improvements and renovations, they can be upgraded to Class A properties.  They also have the potential for steady cash flow.

In the midst of this trend, Class C properties are attracting a wide demographic of investors.  However, is a Class C property a good real estate investment?  There is a lot of information out there about investing in Class C properties, some of which are quite misleading.  Before we find out the truth, let’s first have a good understanding of this property class.

Class C Property

Class C properties are usually old buildings that are more than 30 years old with minimal amenities and outdated systems.  In fact, they usually have most of their original appliances and systems.  Many of these investment properties show visible deterioration and often have deferred maintenance issues.  Due to their poor condition, they tend to have lower upfront costs compared to the other property classes.  However, they will often require extensive renovations and hands-on maintenance.  As a real estate investor, you have to invest some money in repairing the structure and mechanical systems.  Some properties will require significant renovation work before they can be expected to provide steady cash flows.  Despite its apparent wear, a Class C property itself can still be habitable.

A Class C property will often be located in a less desirable, low-income neighborhood.  Class C locations usually have high crime rates and lack amenities such as good schools, restaurants, and good infrastructure.  The tenants in these areas are more likely to be on government subsidies or work low-wage jobs.  This may contribute to vacancies, high turnover, and evictions.  The properties usually net lower rental rates compared to Class A or Class B properties.  The rental rates will often be below the average for the area.

What Are the Benefits of Investing in a Class C Property?

With all the negative characteristics of Class C properties, you may be wondering why an investor would want to invest in a Class C property.  One aspect that makes a Class C property a good real estate investment is the low acquisition cost.  They are cheaper than Class A and Class B properties and the rental rate is usually more than 1% of the acquisition cost.  Therefore, the return on investment when investing in these properties is higher in terms of cash flow and cap rates.  Out of all multi family asset classes, these properties offer the potential for the highest cash flow.  Since areas with this type of rental property tend to have low-wage tenants, home ownership is usually a big challenge.  Therefore, you will have a deep pool of renters if you decide to buy Class C properties for investment.  If your real estate investment strategy focuses on cash flow, then Class C properties may be a good investment. With the right strategy, it can be very lucrative.

There are some real estate investors who seek out Class C properties because of the amazing potential in renovating and upgrading them.  They allow real estate investors opportunities to enjoy a significant return on investment by making small improvements on the property.  With proper upgrades, they can realize larger returns.

What Are the Drawbacks?

Even though a Class C property has an opportunity for strong cash flow if managed well, its potential for natural appreciation is usually very low or not to be expected due to the location. If you are looking for a capital gain, then investing in a Class C property may not be a good idea.

This type of real estate investment also carries higher risks since it will need more extensive improvements and ongoing management.  One mistake many investors make when buying a Class C property is underestimating repairs and maintenance expenses. This can hugely affect their rate of return. With the type of tenants, property management will need to be more intensive. You will require greater oversight to deal with tenant problems, perform maintenance, and collect rent.

Financing can also be a problem when investing in this property class. Due to the poor condition of these properties, an investor often has fewer options for investment property financing. This can make pursuing a deal quite challenging compared to buying Class A or Class B properties. You may be forced to look for alternative sources of investment financing.

In Conclusion

Is it worth investing in a Class C property? Well, that’s up to you and the investment strategy you have set. With the right strategy, Class C properties can be very lucrative real estate investments and offer unique opportunities to investors. However, it is important to understand the relationship between risk and return when buying multi family homes for investment. If you are looking for real estate investments with strong cash flow but real estate appreciation is less important to you, Class C properties would be the best fit. However, they carry the highest risk of any property class. Before you invest in a Class C property, you must factor in the costs of renovating and managing this type of real estate.

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