November 11, 2020
Commercial real estate (CRE) encompasses a wide variety of buildings and properties. In order to help you quickly differentiate between different types properties and the quality of the buildings on those properties, a system of classifications is widely used.
If you’re new to the world of CRE, these terms don’t just come naturally. Here are the basics.
Within CRE, you have a few broad categories of properties. These are the main ones you’ll encounter, but they may also be broken into smaller sub-categories.
These are properties used for industrial purposes. Generally, they are occupied by a single tenant who operates a B2B company rather than a B2C company. The exception is a company which operates in an industrial space to process and ship goods to consumers who order online. Examples are warehouses and processing centers.
Investment properties with at least 5 separate housing units are categorized as multifamily properties. These range from apartment buildings to duplexes or housing communities. You will often hear of multifamily referring to apartment buildings.
In general, retail spaces are defined as those which are leased out to tenants operating B2C companies that sell direct to consumers. Retail can have tenants in many different industries.
Office properties are those which rent out spaces to companies or individuals in order to work. They are often customized to fit the needs of the particular tenant.
Some additional categories are also mentioned, but they can be lumped into large, more broad categories. Examples are medical real estate and hospitality real estate.
Once you’ve narrowed down the broad category, you can get into the nitty gritty of building classifications. The most commonly used classifications are just letters from A to C, and sometimes D.
There are the top buildings in any category. Class A buildings are either new or like new, so they don’t need any renovations. These are not value add properties.
Class A is appealing to investors looking for low risk properties. Most class A buildings have solid cash flow, which is where most of the returns will come. Investors cannot expect a lot of value appreciation, especially since these buildings are already in great condition and are often not undervalued.
These are buildings which are older, but still in good condition. They may be as old as 20 or 30 years old, but there are no significant issues. The worst you can expect with an average class B building is for it to be outdated, to lack amenities, and to require some renovations.
Class B buildings tend to allow for some value add, but it’s not always necessary. In a higher end class B, you may not need to renovate immediately. However, renovations are likely to increase the value of the property, giving you an equity return on top of the cash flow returns. These properties are higher risk than class A but are still not high risk.
On the lower end of the classifications are class C properties. These are much older buildings, usually 30+ years old, which are not in good condition. They are likely still habitable and usable by tenants, but you are likely to receive under market rents unless you do value add renovations.
A Class C building is a riskier investment. You may be able to get a large return in the form of value growth from renovations, but cash flow is not as strong.
While many brokers consider class C as the lowest classification for buildings, some also refer to class D buildings. These are very old, worn-down buildings that need significant improvements to be valuable to an investor. A class D building may not even be habitable upon purchase. This asset class is highly risky and may require a lot of investment before there can be any returns realized.
Sometimes building classifications are less like alphabet soup and more like school grades. When people want to make distinctions between buildings within the same category, they may sometimes add a plus or minus to the class distinction.
Class B+ multifamily property would be on the upper end of the class B category, while class B- properties would be on the lower end of that spectrum without reaching class C.
The extra plusses and minuses are not used by everyone. But, you should be aware of what they mean before you encounter them.
In general, all of these categories and classifications are used to help investors differentiate between different properties in various markets. There are no firm rules about which building fits into each category, but it’s good to be aware of the guidelines so you can have some understanding of what people mean when they refer to a specific building category and class.
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