In order to find the best real estate investments, enjoy financial growth, and make money in real estate, you need to have a strategy. What grade of properties are you going to buy? Multifamily commercial real estate is graded on an A through D scale.
-A Grade: New, 0 to 15 years old
-B Grade: 15 to 30 years old
-C Grade: 30 to 45 years old
-D Grade: 45 years old and older
Having said that, these lines are blurry. While age of a property is significant, condition of the property is also a contributing factor. Consequently, it is not uncommon to see overlap at the margins. In other words, 20 year old A grade properties do exist as do 25 year old C grade properties, for example.
When taking into consideration both age and condition, you get a more complete picture:
-A Grade: New and frequently upscale with multiple amenities. These are generally the most expensive properties in an area and usually are purchased by institutional buyers. They tend to give off lower levels of cash-flow, but also tend to appreciate the most.
-B Grade: Tend to be rented by middle class renters with stable performance. They generally have the ability to both cash flow and appreciate.
-C Grade: These tend to be rented by blue-collar service type employees. You can start to see government assistance like section 8 in this grade. These can be cash cows, but tend to have lower levels of appreciation. Deferred maintenance, environmental issues, and tenant base can sometimes be an issue.
-D Grade: Very old with deferred maintenance and functional obsolescence. Tenant base is a real issue creating lots of work for management.
Just as properties can be graded, so can the neighborhood in which the property sits.
-A Grade: These are newer and affluent areas of town. They tend to be filled with white collar workers and are often within the path of growth. They frequently are filled with high-end retail and restaurants. They have some of the best schools in the city and crime is very low.
-B Grade: These areas are filled with middle class and upper middle class residents. Schools are generally above average and both violent and property crime is low. While these areas are not exactly new, they are stable and filled with national chain retail and restaurants.
-C Grade: These areas are generally declining, but not necessarily dangerous. Schools are below average and property crime is relatively high. Violent crime is at or above average, but not sky high. It is not uncommon to see some houses with bars on the windows and a smattering of graffiti. As for retail shopping centers, you will start to notice things like pawn shops, tattoo parlors, same-day lending facilities, rent-to-own furniture stores, adult bookstores, and laundromats.
-D Grade: These are the most dangerous areas of town. They are frequently gang infested and they account for the vast majority of an MSA’s violent crime. Schools are failing and most people don’t feel safe driving through these areas. It is not uncommon to see a disproportionate amount of industrial real estate in these areas.
Most thriving MSA’s are predominantly made up of B and C areas, with a minority of areas being A and D.
STRATEGIES THAT WORK
Now that you can grade properties and neighborhoods, what is your strategy? Let me start by saying that there are strategies that can make money in any of these property and neighborhood grades. Having said that, I don’t recommend investing in D grade properties or areas. These are labor intensive properties in scary neighborhoods. Life is just too short to be a slumlord.
In general, you should be wary of purchasing a higher grade asset than area grade. For example, buying an A asset in B or C area or a B asset in a C area is usually not advisable. Doing so can have a drag on both appreciation and rent growth leading to lower returns.
On the other hand, matching asset grade with neighborhood grade is a popular strategy. In other words, buying an A asset in an A area, a B in a B, or a C in a C. This can be a very good strategy as can buying an asset in a higher grade area. I really like the idea of buying a C property in a B or A area as well as buying a B property in an A area. These type of purchases can allow for upward pressure on both rent growth and appreciation leading to maximum returns.
To Your Wealth!
Dennis Bethel, M.D.
P.S. If you are going to make money in real estate and enjoy financial growth by buying the best real estate investments, you need to know how to pass the grade when it comes to matching your assets with their neighborhoods.