Turnkey Properties: Interpretation of Property Classifications

Typically I like to keep my writings short so that I am providing useful information that everyone has time to read. This one is not short, but I feel one of the more important blogs I have published because we are talking about defining property classes, which I believe to be largely misunderstood. We have built our business on reputation and transparency, thus why I think this is an important blog to understand our classification of property, which I believe firmly that very few in our industry are being honest about. Being active on Bigger Pockets, it took me a couple of years to realize that when individuals were talking about Class C, in most cases, they are really holding a Class D asset. Also, I see a lot of sellers on Bigger Pockets calling Class A properties that are really Class B. Obviously, it is important to know what you are buying because the strategy, especially the exit strategy vary from class to class. Personally, I own 7 class A, 4 class B and 6 class C. What does that mean? Below is our interpretation of the property classifications.

Class A: Most sales in Class A are to owner-occupants—there are very few investor sales. Typically, Class A real estate is found in stable areas that have appreciation at or above the market average. These properties are often in neighborhoods with better schools and very few multifamily homes, or what one would assume is rental housing. Tenants move into these properties because they want great neighborhoods with great schools. Owner cash flow will be lower, but there a higher probability of a better tenant profile. The risk can be longer periods of vacancy, especially during October through March, the reason being that individuals who can afford the higher rent of these Class A rental properties are typically homeowners themselves. The sweet spot for rent on a Class A property in most areas is $1,195 to $1,295, but select areas can command even higher prices. Typically the higher the rent, the smaller the return. Hedge funds love to invest in Class A because generally there are less issues and more qualified tenants. For a complete investor portfolio, Class A property is good to have. If I had my choice on a 10-property portfolio, I would only own Class A properties, but only if they were all paid off. Unfortunately, I don’t have $1.5 million laying around to pull this off, thus, I have a diverse portfolio of all 3 classes. The exit strategy is likely owner-occupant because there are not as many investors looking for Class A properties because the returns are lower. Because of the owner-occupant exit strategy, we suggest listing the home for sale when it is vacant in order to address any deferred maintenance that may show up on an inspection report and to make it showable for retail buyers. This strategy helps to maximize the sales price, but it also means this type of property is the least liquid. Also, while the home is vacant, you are incurring mortgage payments. If the property takes two to four months to sell, your bottom line is affected dramatically. Remember that the strength of the local market and overall housing economy comes into place when listing any type of property. In other words, there are a lot of moving parts out of your control that come into play when selling any home. Always aim to protect your investment.

Class B: This real estate class is still bought and sold as more owner-occupant than investor sale. Rates vary from 60–70 owner-occupant percentage, but that can vary. The potential cash flow of Class B properties is attractive. Class B properties appreciate typically at or slightly below the market average. Rental during the holiday season can be more challenging, but certainly not out of the question. Class B properties are in good areas that typically rent within 30 to 45 days. The sweet spot for rent is $950 to $1,150 for a three-bedroom, two-bathroom home. An additional fourth bedroom can command more than $1,150 in the right area. Most of what we sell in this class is because the price point combined with desire for investors to be in solid neighborhoods. For Memphis & Little Rock area renters, schools tend to not be as much of a factor. Tenants care more about the actual house and the area where it’s located. Convenience and familiarity, along with their circle of friends and family living close by drives the tenant to the area. Exit strategy can be by owner-occupant or investor. The same owner-occupied selling strategy comes into play here as with Class A properties, but as it is a Class B neighborhood, the sale will likely take a little longer. Investor sales are more common in Class B areas because the cash flow is appealing. But selling a Class B to an investor likely means leaving some dollars on the table. This is because the property will have appreciated, thus selling at the actual retail value will not be as appealing because the cash flow won’t be as high. A good example here is buying a property in 2018 that rents for $1,095 and sells for $109,500. The value of that home is likely around $109,500 at the time of purchase. In seven years, that property could be worth $130,000, but rent has only gone up to $1,195. A value of $130,000 and a rental price of $1,195 do not look attractive to an investor buyer. Remember, most investors are buying for cash flow, not equity. Equity is simply an added bonus, but if the property does not produce cash flow, then the reason for the purchase will not accomplish the buyer’s investment goals.

Class C: This real estate class consists of more investor sales than owner-occupant sales. Despite popular belief on investment message boards, these are not bad neighborhoods, but rather, solid lower-middle class neighborhoods where the household income is $30,000 to $40,000. We have seen that there are big misconceptions about Class B and C. Often, when people refer to Class C, they are really referring to Class D; and when they talk about Class B, they are really talking about Class C. In most cities in the Mid-West and South, the target rents appeal to the largest portion of the population, which is why they typically rent faster than any other class. These are nice and stable areas, but during and after the housing crash in 2010 and because of the price points, investors bought these properties in large quantities. In our markets, like B class, schools are not a driving factor, but rather, convenience and familiarity for the tenants. The exit strategy is likely selling to another investor. This class is the easiest to exit because the strategy is clear: another investor will be buying the property and it will be easier to sell while the property is occupied and cash-flowing. What is the downside? Appreciation depends on the ability ask higher rent since investors are the ones likely to buy. Even though these are good areas, there will typically be higher crime, which has a higher chance for vandalism or home invasion while vacant. Which, by the way, can happen in any area. Tenants in these homes have less income set aside for emergencies, thus simple disruptions in their life such as a $700 car repair can have a bigger impact on their finances. This economic situation and other non-measurable life events cause a higher rate of delinquent payments. There is certainly a correlation between real estate class and renter profile in regards to on-time rent payment.
Class D: We want our clients to avoid Class D properties, especially as an out-of-state buyer. Class D properties are in high-crime areas and are much more likely to have high tenant turnover. These properties are generally not well-kept by owners and tenants. Owners get tired of putting money into these properties as the tenants tear them up, and when they go vacant, they are at a high risk of vandalism. Success can be had here, but it is critical to be very close to a 2:1 rent-to-buy ratio. These properties should be managed by a property manager who has a large presence in these areas because they need employees to check on these homes almost daily while vacant