Like any type of investment, Commercial real estate investing comes with a specific set of terminology that helps align all participating stakeholders. One key component of real estate investing definitions revolves around building classifications. In this article, we’ll cover the classifications you need to know to get started in commercial real estate investing.
What Are Building Classifications in Commercial Real Estate?
Building classifications in commercial real estate provide a succinct, high-level understanding of the property’s age, location, finishes, amenities, condition, and rental rates compared to similar types of real estate in its market.
Although the precise distinctions between building classes can vary from market to market and property type to property type, they are denoted using three letters: A, B, and C.
As mentioned above, it’s important to remember that building classifications in commercial real estate are broad guidelines that can vary in their meaning from market to market. In other words, a Class A multifamily in the heart of Miami probably looks different than a Class A multifamily in a rural Kansas town.
With that nuance in mind, let’s look at the three classes in more detail.
What is Class A Commercial Real Estate?
Class A properties are the nicest and best properties in the market. Class A commercial real estate is in excellent condition, typically built or significantly renovated within the last ten to fifteen years, located in a great part of the market, and generates the highest rent prices in the market.
Class A commercial real estate properties are often found in or close to the Central Business Districts and/or most prestigious areas of the city. They are in prominent places with the most accessibility to everything the city offers.
Due to their great physical condition and consistent cash flow supported by a high-earning tenant base, Class A properties are regarded as the least risky investment class. However, since they’re in such great condition and have little value-add opportunities, Class A properties typically don’t gain as much appreciation as other value-add investments. Nevertheless, Class A properties are still valuable and frequently appeal to “cash flow” investors who place more value on stable income than price appreciation.
What is Class B Commercial Real Estate?
Class B commercial real estate properties are one tier beneath class A properties. This does not imply that they are subpar structures; rather, they’re just not as pristine as Class A buildings, and they aren’t located in the same level of prime location as Class A properties.
Class B commercial real estate properties are generally well-maintained but may require minor upgrades due to aging. They’re often older or have not been renovated in more than 10 to 15 years. Due to their condition, these structures are frequently sought after by value-add investors because they can execute minimal renovations and increase rents for a sound investment.
Class B buildings often have lower rents than Class A, which makes them affordable for small to medium-sized businesses and people with median incomes. Class B properties generate returns with a more even balance of price appreciation and income.
What is Class C Commercial Real Estate?
Class C commercial real estate properties are older, out-of-date, and need a medium to large renovation. Class C properties are often older than 20 years old and haven’t been updated in the last 20–30 years. The finishes on Class C properties are typically outdated and need to be replaced because they are either broken or no longer functional. Class C properties also typically need to upgrade or repair the infrastructure and mechanical systems such as roofs, parking lots, HVAC systems, and plumbing. Class C buildings often have cheaper rents than Class B, making them the most affordable commercial real estate class for small businesses and tenants with lower incomes.
Commercial real estate properties in Class C are less expensive per square foot or per unit than Class A and Class B properties, but because of the high capital investment needed for intensive renovations and the brittle nature of the tenant’s income streams, Class C properties can be riskier than Class A or Class B. Nevertheless, Class C properties can offer the highest ROI of the three classes, which makes them alluring for investors that have a high-risk tolerance and the operational know-how to select good properties and execute a large-scale renovation on budget.
How Do Building Classes Apply to Each Type of Commercial Real Estate?
If you’d like to learn more about the six types of commercial real estate and how building classes apply to them, explore the following articles:
- What is Multifamily Real Estate?
- What is Office Real Estate?
- What is Industrial Real Estate?
- What is Retail Real Estate?
- What is Hospitality Real Estate?
- What is Special Purpose Real Estate?
Why Building Classes are Important in Commercial Real Estate?
Simply said, the building class of a commercial property is important since it provides potential investors a quick way to gauge the essence of the property as well as the risk/return profile of the investment. Despite the classifications’ potential for subjectivity, there is enough consistency to make them reliable for estimation purposes and are thus widely used and broadly understood in the sector.