Multifamily Property; Class B or C? Why?

Question

When searching for multifamily properties which have the greatest ROI potential between Class B & C properties? Why do you feel the way you do?

Thanks in advance.

Kenneth Reimer · Answer

@Ben Leybovich Just to play devil's advocate here, if you assume that Class is correlated to cap rate, can't we conclude that class has everything to do with ROI? Thoughts?

@Duncan Hayes Theoretically, a free market would price a higher ROI in an inferior location. Otherwise, why would anyone buy a C location? However, the idea of risk isn't considered in your question. In my market, I can buy a true 6% cap in class D areas, or I can buy a 4% cap in an A area. My unleveraged ROI is higher in the D area, but weighing lower returns with a more durable investment is a very important distinction. In my humble opinion, the first thing to consider in an investment is how you protect against your downside. What are your thoughts?

Greg Dickerson · Answer

@Duncan Hayes Real Estate is hyper local. It really comes down to the market, location within the market and the asset. As @Taylor L. mentioned your surroundings play a big role in value and upside potential.

Value is all about income which is not always about rent increases alone. You want an asset with potential to enhance operations, increase other income, increase economic vacancy and raise rents. This can happen with all classes of multifamily if you can find the right deal.

Nicole Heasley Beitenman · Answer

C+ is my favorite. The tenants are blue-collar workers. They have good jobs but just don't care about frills. Inventory is old and maybe a little run down, but crime rates are low. You can make minor updates and stand out from your competition (and push your rent up easier). They're low maintenance because they know how to do a lot of things themselves, so you won't get calls unless a real repair is needed. Rents are a hair lower, but so are home values, so it's kind of a wash.

Ben Leybovich · Answer

What's cap rate got to do with returns? Do you underwrite to cap rate, or IRR, COC, Multiple? The latter are metrics of return. Cap rate is a market-driven metric that indicates investor sentiment and has nothing to do with returns.

Well, it does, but not what you think :)

Paul Moore · Answer

@Duncan Hayes.  In my experience, one of the distinguishing differences b/w a B and a C class property is the ability to effectively implement value-adds. Of course, this is very subjective, and others may have a different definition. But in general, I would say that even if you improve most C properties, you are dealing with a tenant base who has limited finances and you are limited by demographic factors such as crime rate and income in the area.

But many B class properties, in my world, are in areas that have the potential for a commensurate rent increase based on upgrades. So there is more ROI potential from appreciation.

Furthermore, the hassles and risks for a newer operator are generally higher in a C property. I think the skill and experience level needed may be higher.

That is my 2 cents. Good luck!

Tj Hines · Answer

@Duncan Hayes it really all depends. Every deal is different. You may be able to find B properties that produce more ROI than C properties and vice versa. Really all depends on a lot variables and factors. Are you buying class C in a B area?  Or are you buying a class C property in a B area? Hopefully you'll always be looking to trade up in repositioning not down. I think that both classes have the recession proof label on them due to the affordability of the housing.

Taylor L. · Answer

Depends on the area. If you find a B property surrounded by As, great! Probably some upside there. If you get a C property surrounded by Ds, you're already the best game in town. It's all about the neighborhood and surrounding economy. All else being equal, I'd prefer to have a B class asset because tenants are generally in a better financial position.

Kenneth Reimer · Answer

@Michael Ealy The relationship between cap rate and cash on cash return has nothing to do with location assumptions and it would be wrong to learn that it does. A mathematical formula doesn't make assumptions, it's objective. Now, if you'd like to take the conversation a step further and delve into how in-place cap rates aren't as important because they can be indicative of potentially higher future returns, then that's a great point to make. I make the distinction because there are new investors reading through these forums trying to learn and saying that a capitalization rate doesn't have anything to do with returns is plain wrong. To say that a cap rate on actual numbers is indicative of your potential return would of course not be accurate, but you guys aren't expounding on your ideas well enough to make it clear.

Yes, a cap rate isn't the end all be all metric for evaluating a deal. Yes, you can buy a 34% cap in an A location if the seller didn't know what they were doing. No, real estate is not an efficient market. But, cap rates absolutely have to do with returns. To say they don't is empirically wrong. Debating how prudent cap rates are is a whole different conversation.

Michael Ealy · Answer

Kenneth,

Ben is an experienced apartment syndicator and probably owns more than 1,000 apartment units by now. So there's a lot more wisdom with experience than with theory...agreed?

Your theory that cap rate and CCR is related - although true - is based on the assumption that you can only buy a building in an area with the same cap rate for the area. Meaning, you pay 5% (using all cash) for a building with a cap rate of 5%. It rings of the Market is Efficient theory, which maybe true in the stock market but is not really true for real estate.

I can buy a building in an area with 5% cap and I can pay the equivalent of a 10% cap. How? I can buy from distressed sellers, or buildings that are not properly managed, or with rents that are way under value. That's really where money is made. So, I can literally buy in a B area and make the same CCR as an operator who buys in a C area.

Makes sense?

Kenneth Reimer · Answer

@Ben Leybovich So are you concluding that IRR, CoC, and GRMs are not market-driven metrics that indicate investor sentiment? That's silly. The cash on cash return is just the leveraged return that is calculated using cap rate as an input.

How can the cap rate, a metric that defines your unleveraged rate of return, not have anything to do with returns?

Multifamily Property; Class B or C? Why?

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