The words “risk” and “reward” are two of the most popular terms in the lexicon of real estate investing. As simple as they sound, defining these terms requires an in-depth assessment of the physical and financial characteristics of a property. These include but are not limited to its age, location, tenant(s), tenant credit, the potential for appreciation, and rental income.
After all risk-and-reward factors are assessed, an investment property is generally given one of three property ratings: A, B, or C. Knowing these ratings, or “classes” helps isolate which type of property or properties best suit your risk tolerance and financial goals. Since diversification balances risk and reward, a blend of Class A, B, and C real estate investments may be the solution for you.
Keep reading to learn what each classification or rating means and how you can benefit from owning a Class A, B or C property, or a combination of all.
Property Ratings Help to Determine Value
Class A, B, and C property ratings make it easy for buyer’s advisors and investors to communicate the value when discussing investment opportunities.
For example, a B-rated property would typically carry more risk and offer less reward than an A-rated property would likely offer, but more reward and less risk than a C-rated property. The good news is that it is possible to make money investing in any of these property classes once you understand the pros and cons and what each offers in the way of income.
What are A-rated Properties?
An A-rating is given to properties that have the best buildings in the best locations in their market and area, such as triple net (NNN) lease properties. They are usually new (under 15 years old) or newly renovated with top-of-the-line features and amenities. High-credit, often investment-grade tenants will rent them and operate with long-term leases. Class A properties carry the least amount of risk, therefore they offer lower cap rates than other types of real estate.
A-rated properties pros and cons:
- Less than 15-years old or newly remodeled with no obsolescence.
- In prime traffic areas or areas that fit their market niche.
- Tenanted by high-income, high-credit tenants.
- Low vacancy rates.
- Highest rent.
- Easiest to manage with little to no management or maintenance costs.
- More easily financed with better terms than Class B/C properties.
- Carry a lower cap rate due to the low risk but have the potential for a comparable internal rate of return (IRR) of higher-risk properties.
Good examples of A-rated properties include Dollar General, Walgreens, Taco Bell, Firestone, and Montessori child care assets. Most NNN investments carry an A-rating because they are generally tenanted by investment-grade, billion-dollar corporations with long-term lease guarantees in prime locations.
Class A properties will be your most reliable sources of income with the least amount of financial risk, and in the case of triple net lease properties, the least amount of management and maintenance.
Class A properties are considered the safest real estate investments with the most reliable income, which equates to lower risk and lower cap rates. However, when tax opportunities are taken into consideration, Class A investments can rival higher-risk properties’ internal rate of return at 7–10%.
What are B-rated Properties?
B-rated properties are typically over 15 years old, have lower income tenants than A-rated properties, and have lower rental income than A-rated properties. However, this does not mean they are not a good investment. They are often the sweet spot between low risk and high risk with a solid potential for growth and appreciation and good returns.
B-rated properties pros and cons:
- Lower priced than most Class A properties.
- Usually older than 15 years, with improvement potential.
- Slightly off the beaten path, near bus lines, or walkable/bikeable to prime locations.
- Tenanted by a range of tenant types: individual business owners, medium-credit tenants, less-established businesses, and residents who are less inclined to sign long-term leases.
- Fairly easy to tenant and re-tenant.
- In the median range for rental income.
- In a higher cap rate category due to higher risk.
- Primed for growth potential and appreciation.
- More costly due to ongoing maintenance and capital improvements.
It is important to note that Class B properties can sometimes become A-rated properties. For example, if a B rating is based on location, as a town grows and experiences urban sprawl, a retail store or QSR might become worth more. Just the same, if an older Class B fast-food restaurant were to add more drive-thru lanes or update with the latest technology, thereby increasing business, it too, could become an A-rated property.
Buying and holding commercial properties in up-and-coming Class B areas can be a good diversification strategy when done thoughtfully and with your risk tolerance and financial goals in mind.
Commercial properties that have a C-rating are typically 25+ years old, have less desirable locations than A-rated and B-rated properties, and are in obvious need of renovation. Consequently, the properties generate the lowest rents, have the highest vacancy rates, and carry the highest risk to the investor.
Class C properties pros and cons:
- Typically have lower acquisition costs.
- Carry higher cap rates and investor risk.
- Located in lower-rent districts or industrial areas.
- Generally require renovation, significant capital expenditures, and heavy maintenance.
- Command lower rents.
- Have higher turnover.
- Can be desirable to a wide range of tenants.
- Offer conversion potential to accommodate a variety of businesses.
- Value-add and appreciation potential.
C-rated investment properties are typically considered the least desirable real estate. However, if you’re willing to renovate, they offer a value-add opportunity, especially if well-located or easily converted to a more in-demand space. For example, flex spaces are in high demand and can be created from an old warehouse or office complex. When a Class C building is thoughtfully updated, it has a chance to reposition to a Class B, or even Class A building, depending on the criteria noted above.
How to Determine if Class A, B, or C is Right for You
When determining which class of property is right for you, assess your budget, financial goals, risk tolerance, and lifestyle.
4 Factors to Assess When Buying Commercial Real Estate
- Desired income and ROI
- Risk Tolerance
Know your budget. It is fair to say that Class A properties are usually the most expensive to purchase, however, NNN properties are the exception. Triple net lease properties are typically A-rated properties with a low barrier to entry – some offer a purchase price as low as $1 million. Class A buildings are also easier to mortgage if you plan on taking on debt to purchase.
Here is an example of what a few of the more popular NNNs sell for:
- Dollar stores: $1–2 million
- Fast-food restaurants: $1.5–2.5 million
- Gas stations/convenience stores: $1–2 million
Class B and Class C properties range in purchase price and financing ability. All three options provide new and seasoned investors the opportunity to diversify.
Desired income and ROI. Class A properties typically have a lower cap rate (4.5–6.5%), but if you choose a NNN investment, since you’re typically not paying all the taxes, insurance, maintenance, and management costs, and there are potential benefits of CSD and other tax opportunities, you can realize a 7–10% overall return, which is on par with gross lease investments (B-rated and C-rated properties). Additionally, NNN investments offer guaranteed monthly income for ten to fifteen years.
Class B and Class C properties are riskier so they offer higher cap rates. When all costs are factored into your ROI, a 10% cap rate can become a 7% IRR. However, B-rated and C-rated properties can be a well-planned addition to a real estate portfolio if you don’t mind the unpredictability.
Risk Tolerance. When considering real estate investing, know your risk tolerance. If you are risk-averse, Class A triple net lease properties are probably your best option. If you like the challenge and management of older properties with more risk, then B-rated and C-rated properties might be for you.
Lifestyle. Most investors never consider how much work is involved in owning real estate and how it impacts their lifestyle. If you simply want to collect money without any hassles, costs, or management, then an A-rated NNN lease property would be a great choice. If you like to renovate and flip properties, then a Class C property may be for you. Depending on whether you’re still working, focusing on a real estate career, or retired, it’s important to consider how much involvement is required and how complex ownership will be.
To Wrap it Up – Understanding A-rated, B-rated, C-rated Real Estate
Understanding A-rated, B-rated, and C-rated real estate will help you choose the right investment property for your financial and lifestyle goals. Class A offers the least amount of risk and hands-on management and the most reliable income, as reflected by the cap rate. Class B and Class C carry more risk, thereby offering a higher cap rate, but they also require active management and higher operating costs.
Whether you are a new or seasoned CRE investor, you may not have considered all the factors that go into buying properties that fit your risk tolerance and desired level of responsibility, which is why engaging an experienced Westwood Net Lease Advisor is a smart move.
Our expert net lease advisors will assist you with the details, crunch the numbers, and ensure the property you purchase is the exact-right property for your goals. From before the property search through closing and thereafter, we represent your best interests and help with the process, at no cost to you. Contact us today for a no-obligation conversation. 314-997-5227