If you’ve ever considered investing in commercial real estate, it’s likely you have noticed properties are often grouped using a letter-based classification system. Generally, buildings are evaluated as either A-class, B-class, or C-class. Though it intuitively makes sense and allows investors to maintain focus on a certain type of asset, hard and fast rules pertaining to why one building is placed into one class and not another can be elusive. So, what exactly do such classifications mean? Is this a purely arbitrary and subjective exercise or might there be something more to it? Let us explore this a little deeper.
Commercial real estate properties (particularly office buildings) are generally described as being A, B, or C class, and in some larger markets, the methodology used is a little more granular, following a more specific grading system (i.e. A can be segmented to A, AA, AA, etc.). This provides a good starting point for our discussion, but it would be useful to find out how each classification is derived.
Classifications of commercial real estate assets need to first be viewed in the context of the market where they are situated, and ‘grades’ are thus based on a comparison of an inventory of buildings within a particular market. For example, within both New York and Bismarck, there are A, B, and C class buildings, but A-class properties within those respective markets are not likely comparable on an apples-to-apples basis.
There is an element of risk embedded in the rating, as it provides an indication of the covenant, or tenant quality such an asset might attract, as well as how well the property might be able to hold its value.
Property calculations are grounded in the assessment of several baseline quality-based metrics. An individual investor makes subjective evaluations based on different factors weighted toward particular attributes most important to them. Overall building classifications are more generic, and are agnostic of subjective opinions. This raises questions like: How might a property rank against each quality-based metric? Does it exceed, meet, or fail against standards? How does this assessment differ from property to property?
What are the main criteria driving the building classification system? Though it can vary, the Building Owners and Managers Association (BOMA) has established a set of standards which include financial considerations, building attributes, location, proximity to amenities, as well as future outlook. Here is BOMA’s list:
Although there is no central authority responsible for making those evaluations, the corporate real estate community—a vast network including brokers, property owners, property managers and land landlords—is very good at organically deriving these ratings.
Geographic context is critical. Continuing with the example we used when comparing assets in local markets, what might be considered an A-class building in Bismarck, may be considered a C-class asset in New York. This may be a function of market size, growth prospects, and economic activity.
For example, New York has a dynamic financial and tech sector that is in a state of continuous change, while Bismarck’s economy may be more reliant on traditional industries such as agricultural wholesaling and oil drilling and extraction.
The types of assets required to accommodate the needs of those industries are very different. This gives us a sense of the importance of context. One building’s A-class status is dependent on how it fares with other buildings nearby.
Time is also an important consideration. A sparkling new building with all the amenities opens in 1988 and is immediately classified as an A-class asset. Over time, ownership changes, and it’s finally purchased by an overseas pension fund that simply views it as a vehicle to make income. Aside from rudimentary maintenance, the building systems haven’t changed, and no substantial renovations have taken place.
Meanwhile, within the same area, new office buildings with updated features have opened, rendering the original building sub-standard in comparison. Over time, the classification drops from an A to a low B. Thus, classes can change over time. In summary, over time a building class rank may change due to:
A class is not fixed and is typically used as a comparative metric against other properties in the area. It’s useful for an investor to analyze potential investments on their own criteria, but not a fully standardized metric broadly shared or objectively derived.
So, what do these classifications mean? It’s difficult to pinpoint anything beyond broad strokes, but reviewing those is useful, so here’s a rundown.
A-class buildings are designated as the highest-quality buildings in a given geographic area. These tend to be newer (i.e., built within the last 15-20 years), with modern fixtures, building systems, and proximity to key amenities such as public transportation, restaurants, and local amenities.
It’s important to note age may, in some cases, not have any material effect on building class at all. In fact, in some cases age can become a notable feature. A perfect example of this can be found in Toronto, where one of the city’s most iconic buildings is The Gooderham Building, known locally as The Flatiron Building. It is a relatively small 5-story facility built in the later stages of the 19th Century.
Despite its age, building owners have been meticulous in ensuring systems, fixtures and amenities remain state of the art. As a result, it is not only considered an A-class asset, but also commands some of the highest rents in the country.
Generally, A-class buildings are situated in central business districts and other mixed-used or commercial hubs, but in large metropolitan areas like San Francisco, Toronto or New York, satellite cities (e.g. San Jose, Mississauga, Brooklyn, Stamford) have built up enough critical mass within their own cores by successfully luring high-quality tenants to their locations, that A-class facilities become an expected part of the satellite cities’ local business landscape.
All such buildings have ready access to local facilities, public transportation, and similar buildings in terms of attributes and features. It should come as no surprise that buildings within this A classification generally command the highest rents.
It stands to reason that buildings in this class often attract the highest profile and lowest-risk tenants (low risk, as the probability of any defaulting on rental payments is almost zero; in this sense, they are often referred to as tenants with the best ‘covenants’). Examples of such tenancies might include venerable financial institutions, global consumer product companies, and prominent technology firms.
The quality of ownership is another distinguishing factor of A-class buildings. Such facilities are typically controlled by institutional owners with extensive portfolios, and geographic footprints that can be national or global in scope. As owning and marketing high-end buildings represent one of the core activities of this type of ownership group, they are committed to ensuring their properties are professionally maintained and building systems are routinely upgraded. Maintenance is almost never deferred, and thorough reviews and building audits ensure potential issues are dealt with before they become problems. Owners like this are also committed to ensuring response times to tenant complaints are always kept to an absolute minimum.
Taken together, these attributes combine to create the building blocks of what an A-class property looks like. In turn, it contributes to their overall quality, value, and desirability. From a financial perspective, the extra expenditures required to maintain such buildings might be high, but this is a critical contributor to overall value.
B-class buildings, as one might suspect, lack the same cachet as A-class, but this should not suggest any substantial decrease in building quality or overall functionality.
With this said, some compromise in quality standards is inevitable compared to their A-class counterparts. Consider the following:
Another interesting dynamic associated with B-class buildings is the degree to which they occupy a wide range in the middle of the bell curve, as they encompass many potential properties. On the lower end, when improvements are made to some C-class properties, they can be bumped up to B; similarly, A-class buildings that may not have been maintained to a certain set of standards, could be ‘demoted’ down to B-class. In this sense, these classifications can be catch-all average categories best likened to Goldilocks’ bowl of porridge: not too hot or not too cold.
Many CRE investors view B-class buildings from an investment lens. Specifically, their tends to be multiple opportunities for asset improvement after acquisition. By improving the condition or quality of the property (or, in extreme cases, lobbying a city to install better public transit, reroute buses, or otherwise improve community services), the building could be promoted to a low A-class, thus enhancing its position if the owners wish to flip it and reap the returns on investment for improvements made.
As such, Class B buildings are often considered the most desired category for building improvements within commercial properties.
Unlike their A-class peers, C-class buildings are given this designation for many reasons that, based on the discussion thus far, may seem intuitive. From an investor’s point of view, they represent the asset investment category having the highest general risk profile.
Key qualities of C-class buildings include:
This naturally begs the question: why are C-class buildings purchased in the first place?
Some CRE investors often sense untapped value in these properties with the right amount of input. Specifically, C-buildings attract flippers; an investor steps in to acquire a building for cheap given its poor quality compared to others in the area. They then invest in renovating and improving the building to the point where it can be repositioned as a B-class asset. Then, rather than operate them for a slow return, they sell for more than the combined total of investment and renovation to profit and move on to repeat the process elsewhere.
This is a particular category of commercial real estate investment. Not everyone likes it; it’s often more hands-on, involves unique problem-solving, and cannot be put on autopilot to generate revenue. However, given the right set of circumstances, C-class buildings can become a significant source of value if improvements, or even changes in market conditions (e.g. higher demand), tip it over the edge or if situational factors (like changes to the city structure, investment in the neighborhood, or other improvements) potentially bump it up to a higher classification.
The class of a parcel of real estate is a factor in its viability as an investment, but it’s not a clear indicator of value, because value needs to be viewed from an individual standpoint. In other words, investing in an A-class building is not better than investing in a Class C building, as it all comes down to an investor’s particular risk tolerance, budgets, and investment goals.
Investors in A-class buildings tend to be more institutional, making purchasing decisions for the goal of achieving passive appreciation, and income over time.
Obviously, maintaining these types of assets is capital-intensive given property management requirements for upkeep. Depending on location and other factors, this will be a steadily appreciating asset which continually throws off income. In short, it is the corporate real estate equivalent of holding a blue-chip stock.
B-class buildings may arguably be considered the most interesting class of buildings, given the potential upside they represent. Indeed, this is where most of the “creative” investments reside. B-class buildings cover a broad volume of assets, so low Class-B buildings, if strategically repurposed or repositioned through relatively small investments can yield strong returns. Conversely, if a Class B building is already well-positioned, the emphasis may be focused on income and long-term appreciation.
C-class buildings tend to be the sandbox where serial flippers play. Depending on what actions are taken at a particular property after acquisition, these buildings can potentially yield a high NOI. For investors with a greater degree of risk tolerance, C-class investments can be extremely lucrative.
One of the keys to understanding which class you generally prefer as an investor is having a firm grasp of your finances. That’s why we recommend using itamlink; as a central platform for real estate taxes and other financial information, it empowers you to have even more of your financial situation at hand, so you can forecast the implications of an investment and the ways it can improve your situation or the ways it might be risky.
Contact us today to Book a Demo and see what itamlink can do for you.
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