Remember the board game Monopoly?
Roll the dice and then move your token (e.g. race car, thimble, etc.) around the board. If you land on open property, then you have the opportunity to buy it. Otherwise, pay the rent if someone owns it. And don’t forget to collect $200 as you pass GO.
Looking back, Monopoly resembles the real estate world quite well.
The board game has 4 sides with properties that increase in value as you travel around. Properties range from the very cheap to the high end luxury. 1 house on Baltic Avenue rents for $20 compared to a house on Boardwalk that rents for $200. That’s a 10x increase!
In the real estate world, properties also range from high to low. Real estate investors often use property classes to quickly characterize a property. Property classes can be A’s, B’s, C’s, or D’s. Whether you knew it or not, as you play Monopoly, you’re actually passing from D class properties all the way to A class ones.
|Property Class||Board Side||Example|
|C||2||New York Avenue|
Taking this analogy further, even the railroad that splits each side of the board is another demarcation. On one side of the tracks, there are slightly more expensive properties with higher rents than properties found on the other side. For instance, side 3 contains yellow properties (e.g Marvin Gardens) after the tracks and red properties (e.g. Illinois Avenue) located before the tracks. So the yellow properties could be classified as B to B+ and the red properties are B to B-.
So why do property classes matter?
If you’re thinking about investing in a turnkey property out-of-state, then you’re going to hear these terms pitched to you. As an investor, you need to see when a seller (e.g. Turnkey company) is really pitching you a C Class property at B Class price.
In this post, I’ll explain what rental property classes are, their general implications, 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. And unlike in Monopoly where you don’t deal with bad tenants or crime, the real world is more complicated.
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 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 generally 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 by 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 typically get a higher rent-to-price ratio with lower class properties and see higher capitalization rates (ratio of the net operating income to the value of the property).
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.
Class B properties sell for more than class C, because they’re more desirable. Also, whenever a property is borderline B and C, nearly always will it be pitched as Class B so that it can be sold for more.
Example — A Real Turnkey Property For Sale
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 in Indianapolis that was marketing a Class B+ property for sale at $97,000. It was a 3 bedroom, 1.5 bath, at just under 1500 square feet.
Class B+ For Sale — Is the Turnkey Full of It?
The turnkey company says it’s a B+. Rather than take their word, let’s 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 $129k.
- 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.
At $75k, the property value is estimated to be far under the median value of $129k for all homes in that city. So according to Zillow, this property is significantly cheaper than most properties in its city. Not that Zillow is always correct, but their relative comparisons are usually accurate.
Further, the median household income within the turnkey property’s zipcode is almost $20k less then the median household income of the entire city. Meaning 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. My guess is that by labeling it a Class B, they’re hoping to sell it to an unsuspecting out-of-state investor for a nice profit at $97k.
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 even after a cosmetic rehab. 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 and the management will reflect that tenant class.
Ultimately, if I had to pick a class, I would argue that this property is a solid C. Possibly even a low C.
In the board game Monopoly, properties range from Baltic Avenue to Boardwalk. Similarly, the real estate world has a range and is 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. Buy and hold investors who prefer higher class properties tend to accept cap rates because they are seeking a less risky investment, less management, or seeking more potential upside by 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.
My favorite Monopoly token was always the race car. Did you have a favorite? Now regarding property classes, what class do you prefer to invest in?
I’d love to hear from you so leave a comment below.