Commercial real estate applies a grading system to assets to rate overall quality and key characteristics. Buildings are classified as A, B, or C, and that ranking is an indicator to help gauge a property’s competitive position in a marketplace and where it fits in relation to market value and rents.
Building class applies to all property types. Although by no means definitive, some descriptions for the three different classes are as follows.
Class A Properties
This is the top tier in a particular market. Some of the key attributes of Class A properties include high-end construction and interior finishes, modern architectural design, state-of-the-art mechanical systems and technology, and a variety of property amenities. Class A properties are assets that usually command the highest possible rents in their respective submarkets.
Class B Properties
Class B properties are a step down from Class A in terms of building quality, location, and amenities. While it’s possible to have a brand new Class B asset, it’s more common that an asset becomes Class B due to age. Class B buildings are typically at least in good condition, and may achieve above-average rents, but rents and property values are lower in comparison to their Class A competitors.
Note: historic assets (even if well maintained) are often rated Class B due to physical aspects that, while charming, are technically outdated.
Class C Properties
This is the lowest rated tier and often considered the least desirable of buildings. Oftentimes, these are older assets that have outdated building systems, design or finishes, or they may be in desperate need of maintenance and renovations. Due to these types of constraints, Class C operators are often relegated to minimizing operating costs as a primary strategy since their revenue upside is limited.
Can classifications change?
As noted in the previous section, buildings can move down or up in classification. A new building with state-of-the-art amenities may easily start out as a Class A property, but it may slip to Class B over time as the building ages, tenant preferences change, or trade areas within a submarket shift. Conversely, it’s possible to move a property up in class through renovation and tenant repositioning. A change in infrastructure or access can shift traffic patterns that create new Class A destinations, or even turn a previous premier location into a less desirable Class C location.
It’s important to note that demand for each class of an asset type can change depending upon cyclical factors as well, such as a recession or periods of strong economic growth.
Are asset classes and returns correlated?
Generally, asset class and returns are not correlated. What is more important is knowing where a property fits within the asset class ranking system and where it’s headed given a particular business plan. This helps to put investment opportunities into context in relation to potential risks and returns. In most commercial real estate markets, demand exists for all three asset classes.
Also note that these categories can be subjective and also can vary widely depending on the individual market or region. For example, a Class A office building in a tertiary market may be viewed as a Class B building in a primary market, such as New York City or Los Angeles. In addition, once assets reach the edge of a classification tier, they lose consensus when it comes to ranking them. Some might consider an asset as Class A- while others might view it as Class B+.
For more information on asset classes, refer to this article: Making the Grade in Real Estate: Understanding Class A, B and C.