In today’s world, we’ve made it a habit to grade nearly everything. A young child’s arithmetic abilities, the strength of concrete and even eggs all receive letter grades. The financial markets equally rely on a grading system to rate stocks, bonds and credit quality—and commercial real estate assets follow suit, also receiving letter grades to express the asset’s physical quality and location.
In real estate, investors consider the grade an indication of the property’s ability to generate income – therefore, its return potential. While there are no official rules about property grades or how to invest in a property with a specific rating, investors rely on them to quickly understand the type of asset and determine an appropriate investment strategy.
Here’s a look into the 4 major ratings in the commercial real estate property grading system, and the best investment strategy to use for each asset type.
Commercial Real Estate Property Ratings
Commercial real estate properties, also called assets, are rated on a standard letter grading scale. Typically, assets are graded A through C. The grading system describes the physical quality of the asset—including the construction quality, architecture, design, age and fixtures and finishes—and the location. While there are generally accepted industry standards, there exists no “official” grade designation, and asset grading is therefore somewhat arbitrary.
Class-A assets are the highest quality tier. This is usually a rating reserved for new construction or luxury properties built in the last 10 to 15 years. Due to their quality, class-A properties attract above market rents and high-quality tenants, and as such trade at the lowest cap rate.
In the next tier, class-B assets are mid-tier vintage buildings with average market rents or just below average market rents. Properties in this category may have some deferred maintenance or require upgrades due to age; however, they are highly functional buildings with stable demand and the ability to provide favorable cash flow. Class-B properties carry a higher cap rate due an elevated risk profile but also carry upside potential if the ownership pursues a capital improvement program.
Class-C assets refer to older building stock. Properties in this tier are often located in undesirable locations or secondary and tertiary markets. As such, they traditionally capture below market rents and have weak demand fundamentals. These properties can also have wide scale deferred maintenance issues or be candidates for redevelopment. However, a redeveloped class-C property could become a class-B property upon renovation.
Four Ways to Invest
Rating and classifying assets provides a great way to describe the quality of a property and appeal to the right type of investor without giving a physical tour. When it comes to investment strategy, the choice generally aligns with asset class quality grades as well. Investment strategies generally fall into four categories—core, core-plus, value-add and opportunistic investments. Each strategy carries a different risk profile related to the quality of the asset at the onset of the investment.
Core Investment Strategy
A core real estate investment is a low-risk investment play. Investors executing a core strategy will target high-quality class-A properties in highly desirable neighborhoods. A core investment might also include a newly renovated class-B property with strong occupancy and stable income. As part of the profile, the property will have strong demand fundamentals and above-average in-place rents. In addition, a core investment will have no existing maintenance or upgrade requirements. This is a fully operational, cash-flowing and stable asset that is already producing healthy investment returns for an existing owner. A core investor simply wants to step into an existing well-managed asset. Because this is a safe and easy investment play, core assets carry the lowest cap rate profile of any other standard commercial real estate investment strategy. Investors should expect to pay more for a core asset and accept a low return in exchange for low risk.
Core-Plus Investment Strategy
A core-plus strategy carries a slightly higher risk profile than a core investment play in exchange for an improved return. In a core-plus strategy, an investor can expect to make some improvements to the existing property to raise net operating income (NOI) and generate a better return. A core-plus investment might require minor improvements, like exterior or interior paint or landscaping, or a property rebranding. Commonly, a core-plus property also has above-average vacancy or other operational challenges. New ownership will drive value through management improvements, like a lease-up strategy, raising rents to the market or re-assessing operating budgets to trim costs.
A newly delivered ground-up development is a great example of a core-plus property. As a new construction asset, the property would be class-A in quality, but the developer will likely only be in the early stages of a lease-up strategy before selling the property to an operator. The new ownership will be responsible for driving building occupancy, setting rents and developing operating budgets and plans to realize the full NOI potential of the property. Other examples of a core-plus investment include a class-B property that is in great condition but in need of a rebrand and new management to improve NOI, or one in need of small property improvements to drive income.
Value-Add Strategy
A value-add strategy is higher risk, wherein investors target class-B and class-C assets in need of large-scale capital improvement plans. Buildings suitable for a value-add business strategy are vintage construction, generally more than 25 years old, and they typically have deferred maintenance issues that impact the functionality of the property. As a result, a value-add property usually needs significant renovations in order to meet modern quality and style standards. As a result, investors can typically purchase a class-B or class-C property below replacement cost and at a higher cap rate to offset the additional investment and give the investor an incentive to take on more risk.
Value-add models are a good fit for investors with an appetite for risk. There are investors that specifically target value-add properties, but these investments can also be a good fit for developers, who have construction and project management expertise and a high risk tolerance.
Opportunistic Strategy
Opportunistic investments are the highest risk category. Often, opportunistic investors will purchase a lower-quality asset out of distress. This might include assets that have fallen into default or are in severe financial distress, properties that are vacant or shuttered, or properties that need a wide-scale redevelopment beyond upgrades and renovation. Opportunistic investors accept a lot of risk in exchange for a deeply discounted buying price and tremendous upside. Opportunistic properties are typically class-C assets or below-grade assets with significant issues, but following a redevelopment, they can become higher quality assets. In addition to being the highest risk, opportunistic investments are also the longest play, taking three years or longer for an owner to realize a return.
Asset grades are as common as cap rates in commercial real estate, but technology is enhancing the concept. Investors can use alternative data sources to better understand the condition of an asset, its return potential and the best investment strategy to extract value. Predictive analytics platforms like Northspyre are reshaping every piece of the investment cycle to deliver actionable solutions and information to investors. Northspyre’s tool can deliver insights into the development cycle to help developers achieve targeted outcomes. Investors are using the same types of technology to vet prospective acquisitions and develop and execute successful strategies. Asset grades will always be a cornerstone of rating an asset, but using data will help provide a clear picture.
Want to learn how technology like Northspyre can help your firm achieve higher returns and minimize risk, even amid economic uncertainty? Download Maximizing Returns: A Real Estate Developer Recession Guide for insights and strategies you can use.
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