Property Classifications & Market Types in Commercial Real Estate
Within multifamily, there are four property classifications. Each classification has distinct property and tenant qualities and investment potential and risk. Investors and lenders will utilize this information when making decisions about the viability of an investment. Disparate pools of buyers will be attracted to each classification, and lenders will formulate this potential when considering financing terms. The risk profile and investment objectives of an investor will determine the property classification to which they are most drawn.
Although Class "D" is included for completeness, most investors will avoid these properties because they tend to be located in high-crime, problematic areas and are very management intensive. These properties are often purchased for cash flow rather than for appreciation potential. The risk profile for these properties is not favorable for most investors.
In the U.S., there are three main types of real estate markets: linear, cyclical, and hybrid. Linear markets are characterized by property prices that are generally the "slow and steady" markets (i.e., little volatility), meaning that they experience gradual price increases without significant fluctuations either up or down. Many of the linear markets tend to be away from the West and East Coasts and toward the middle of the country. Birmingham, Huntsville, Kansas City, and St. Louis are some examples of linear markets. Cyclical markets are generally more expensive markets and are characterized by prices that can experience significant fluctuations up or down. Coastal cities like Los Angeles, San Francisco, Seattle, New York, and New Jersey are examples of cyclical markets. Investors in cyclical markets are susceptible to substantial losses during economic downturns and sharp corrections. Hybrid markets are demonstrating characteristics of an in-between market; the price volatility has increased substantially over a linear market but not to the extent of a cyclical market. Charlotte, Denver, and Phoenix are examples of once linear markets that are now hybrid markets. A once hybrid market, Austin appears to now be a cyclical market given its sizeable appreciation in real estate prices over the last decade.
Also, an area's market type may change over time. For instance, a once linear market may become a hybrid market and even become a cyclical market. A region that experiences continued job and population growth (capital inflows) may eventually transition from a linear market to a hybrid market, then potentially to a cyclical market. These transitions occur as an increase in capital flows into a market and pushes up real estate prices. If these transitions occur, they do so over a period of many years of continuous capital flowing into that market.
Linear markets tend to have the highest cap rates and highest cash flow potential. On the contrary, cyclical markets tend to have the lowest cap rates and the lowest cash flow potential. The hybrid market is the intermediary and tends to have cap rates in between the other two market types. Hybrid markets tend to have marginal cash flow, if any.
Class A, B, C, and D properties exist in all market types.
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