In today’s episode of the Actively Passive Investing Show, Travis compares Class C vs. Class A properties. We talk about the three factors that determine the property class, average cash flow percentages in different classes, how to set a CapEx budget, and risk mitigation in new vs. older properties.
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TRANSCRIPTION
Travis Watts: Welcome, everybody, to another episode of The Actively Passive Show. I’m your host, Travis Watts. I have a very exciting episode today. I hope you find it as exciting as I have. Actually, this topic came from a 60-Second Question, which is a segment that we do on social media for this show. If you guys have a question that you want to ask, you can email travis@ashcroftcapital.com, or email anybody on the Joe Fairless team, and I will answer it for you in 60 seconds or less.
After I answered the question of “Do Class C properties really cash flow better than Class A?” I got to thinking, yes, I answered that in 60 seconds or less. However, I think it bears a lot more detail, and I think it’s a much greater conversation than just giving three quick bullet points.
So to that point, I’ve turned this into a full-length episode. I hope you enjoy it. So real quick, as we get started, I just want to define Class A and Class C, because that’s specifically what this question was about. So a Class A property is your more luxury, it’s your more high end, it’s usually located in a great area, maybe at the center of a major city, that’s been a long-term successful market where lots of people live and lots of jobs are located, very high amenities, great schools in the area, on and on; you kind of get the point from that.
A Class C property falls a couple segments down on the list; we’re skipping over B. So a Class C property would be what I would refer to as more of workforce housing, where your rents are going to be substantially less; you might have a lot less in terms of amenities. For example, it may not have a pool or it may not have a gym for the residents to use or something like that. Sometimes these are on the outskirts of town or not so much centrally located on the corner of Main and Main, so to speak, in the middle of a city. But really, it depends on many factors. Evaluating the class of a property has a lot to do with the age of the property, and a lot to do with the location, and a lot to do with just the tenant demographic and who is living there.
So I think in the industry, there’s kind of this common belief that a Class A property is really an appreciation play, you’re hoping they’re going to buy it, it’s going to appreciate with inflation, and hopefully market rent raises and things like this over time; it’s less about cash flow, oftentimes. What you’ll see on a pro forma is usually a lower cash flow amount, compared to a B or a C property.
And I’ll just lightly touch on a Class B property between an A and a C. So maybe it is an equity appreciation play as well, much like a Class A, but maybe it has some higher cash flow to it as well, because maybe it’s 1980s, 1990s built, and it’s a cheaper purchase price, so maybe there’s a little bit more ROI in terms of that. The same could be said for the risk profile of a Class B; it kind of lies between A and C, which is what we’re talking about here.
So with a Class C property, a lot of what investors get pulled in by when they look at pro formas is the cash flow projections… Because a lot of times you’ll see – I’m just making up these numbers, for example purposes; not a financial adviser, I’m not soliciting any deals, I’m not by about any operators in particular… I’m just saying, if I’m looking at a Class C deal by Joe Schmoe operator out there in the world, I might see a 10% cash flow on a Class C property. Whereas maybe on a Class B, I’m looking at, I don’t know, 7% or 8% cash flow annualized, and then maybe on a Class A, I’m looking at 5% or 6% cash flow. So point being that C usually has that cash flow component. And if it’s a value-add business plan, meaning you’re going to improve the property, hopefully, there’s also a component of equity upside as well. It really depends.
But what we’re talking about today is, does a Class C property really cash flow better than a Class A property, all things considered?
So let’s dive in. So the first thing I want to distinguish is that properties and areas are a different conversation. These are different metrics, both holding a lot of risk points that we need to consider. A Class A area usually has low crime. First of all, it’s usually, like I said earlier, around great school systems, for example, maybe golf courses in the area, maybe nice single-family residences around, with average home prices that are perhaps above average. But guess what? You can have a Class B property located in a class A area, so that’s something to think about as you look at these pro formas, is “Is the property a Class A, B, or C, or is the area a Class A, B, or C?” When you merge those together, what do you get?
And alternatively, a builder could choose to put a brand new building, with state of the art finishes and all the rest, in perhaps kind of a bad location, a C or a D location, on the outskirts of town. So we can’t assume just because something’s newly built, that it’s all Class A and it’s going to do great. We can’t assume just because something’s an older property, it’s not going to perform well. I took a tour of a few 1900’s to 1920 built multifamily projects in Denver, and oh my God, the rents are just out of this world, you wouldn’t even believe. They’ve restored these units. You couldn’t just look at that and say, “Oh, it’s an old building. That’s a Class C or D.” These are luxury, very, very high-end finish buildings.
Something I’ve noticed just being an LP, a limited partner, in these syndications is when I’m looking at underwriting, it seems like there’s a lot of just a blanket template to use. You always assume this percentage as a cap ex, and this percentage as a rehab budget. Of course, that’s not always the case, but I see a lot of this repeat or these assumptions on different things. And they’re not really factoring in the class of the area or the class of the property in all cases. In other words, the numbers I’m looking at aren’t necessarily reflective of what I see the risks to be.
Travis Watts: Let’s talk a little bit about CapEx budgets and ages of properties, just for example purposes. A CapEx is short to say Capital Expenditure. It’s basically a rehab budget for a value-add business plan, we’ll say; a property that you’re renovating. So what I might see, for example purposes – an older property, let’s say it’s built in the 1960s, having a similar or same budget compared to another multifamily deal, a different operator, that’s buying a 2010-built apartment community. The age of a property is a huge risk consideration and it needs to be factored into the underwriting. It’s also a major consideration on what class of property we’re talking about, as we discussed.
So here’s a fun little lesson for you… So older properties – I can almost promise you this, older properties are going to inevitably have more problems compared to newer properties, trust me on this. I’ll give a single-family example. I owned a 1932 Tudor home; three bed, two bath; maybe it’s a little bit more than that, I can’t remember. But it had a boiler system, it had an evaporative cooler instead of centralized AC… Older bones, looked beautiful on the inside, been remodeled probably 100 times over 100 years. And equally so, I owned virtually, a brand new home. I think when we bought it it was about two, maybe three years old. So pretty much a brand new home. Let me tell you, a world of difference.
There’s items you have to consider; obviously the roof, the HVAC system, lead-based paint in older properties, asbestos, foundation cracks, cosmetic repairs, underground lines for downspouts, retaining walls that may be failing, and might I mention, sewer lines. That older home that I was just talking about, at one point, we were renting it out as an Airbnb, and we had some tenants in there. And the sewer line in the dead of winter – of course, this always happens around 11:00am to 1:00am; I don’t know what it is about that time frame… The sewer line collapsed underground, and backed up raw sewage into the basement of the home, where tenants were actually staying in that area.
Now the repair was, believe it or not, actually pretty minor in terms of I guess how collapses go, but it was still $8,000 out of pocket back then; who knows with inflation, what that would cost today… And that was only doing just the minimum viable product of a repair. And guess what? It wasn’t covered by insurance. Why? Because the sewer line was outside the foundation of the home. And if you read the fine print on my insurance policy, anything outside the foundation is not covered. Convenient. But I digress.
Back to talking about CapEx. I’m a big advocate for limited partners and investors really taking a heavy look at underwriting, and look at the line by line, does it make sense? Ask questions, listen to webinars, listen to recorded calls, figure out why things are the way that they are, based on the beliefs of the operator. It’s so important, because something overlooked of 100 grand, 200 grand could actually make a substantial difference over your returns and the lifetime of the deal that you may be investing in.
So what are you looking for exactly? I could make a whole episode on that and maybe I will, but from a high level, if it’s a newer property, things are going to have a longer lifespan to them, which means that the CapEx reserves could be lower, possibly should be lower, compared to that example I gave of a 1960s property where you might have a lot of things pop up that could be unknowns, or boiler systems that you got to tinker with, or whatever might happen.
So let’s talk a little bit about tenant base. And what I’m talking about is when you have a Class A property renting at $3,000 per month, let’s say, in rent, compared to a Class C, where you get the same three-bedroom unit for $1,400 per month… That’s a big difference in affordability; that all is reflective of your tenant base – who’s living there, what jobs they have.
Something you want to be tuned into or asked questions on is specifically the length of tenancy, what are the average lease lengths, and know about historics on how many people break leases, how many people are non-paying, what collections are, and probably most important, what the turn costs are historically, and then accurately budgeting for the future when you do have to turn over these units, which in my experience, Class C properties turn over a lot quicker than Class A. And it just also seems to be, in my experience, that the lower the rents are, the more wear and tear seems to happen, the more damage seems to pop up on these units. Turn cost on the units can be extremely high, because usually, normal wear and tear isn’t deducted from a renter’s security deposit, it’s just basically absorbed. So the more minor wear and tear that’s happening, combined with quicker turnover, equals more costs, in addition to people breaking leases, moving out etc.
Equally so, this is why you do have a damage deposit in play. But I can tell you, from personal experience, when I ran my own properties doing single family, sometimes that damage will exceed the damage deposit that you have. But it’s just at that amount where pursuing legal action just isn’t worth your time, effort and money. So that can be an additional loss that’s unaccounted for. Not all residents that are renting from a Class C property have the financial means to pay for that level of damage; even if they said they wanted to, they may not be able to.
So a lot of this risk can be mitigated through tenant screening, one on one; I would never skip that step. I made that mistake as well and put some horrible tenants in one of my properties and paid dearly for it. Always check on income, maybe 3-4x the income, it just kind of depends on what the monthly rent is, talking about gross income; previous landlord, referrals, credit scores, previous eviction on criminal activity, things of that sort.
This episode is certainly not to discourage you or anybody listening from investing in Class C properties. I have invested in Class C properties. And you know what? I’ll share with you two stories; in fairness, a bad story and a good story, that are both true stories in my experience.
So the first is, I was an investor in what I would say was a C-minus asset out in Ohio, and I was a limited partner in a multifamily syndication. At one point, there was a stabbing on the property. And I kid you not, eight residents within the next week broke their leases, without notice, did not pay for breaking their leases per the lease terms, and vacated the property because they did not feel safe on the property. On top of that, a few of these residents left a review, talking about it. What do you think that did to now the prospective renters looking to potentially rent there? So you guys, it all kind of comes down to higher risk, higher reward.
So let me share with you the good story. So I was an investor in a C property; it could have been a C-minus… I would just call it a standard C property… Where we only held that asset probably under two years. Again, I was a limited partner in a syndication; we ended up selling and we made over a 30% IRR return to the investors. It was a solid deal, it was a solid play. But you know what? The thing is, with that, I feel like, we got lucky. These things that we’re talking about, the crime and the what-ifs and the sewer lines and the asbestos – none of this stuff came up. Hopefully, it didn’t have any of those things, obviously… But had it come up, and been, “Oh, we have to do this asbestos mitigation or whatnot, that’s going to cost $100,000”, that would have just dwarfed our returns. So it’s just, again, higher risk, higher reward; it’s something to be aware of, something to think about in terms of, again, the theme of the show – is a Class C property really cash flowing higher than a Class A, all things considered, including the risk points?
Travis Watts: So as I mentioned, I do invest in class A, Class B and occasionally I’ve done some Class C investments. So in fairness, I want to share with you my own portfolio in 2020, and a few metrics that I thought were interesting. I only did an analysis because this took a while on Class A and Class B. So the occupancy actually increased slightly, about almost half a percent over the course of 2020. Income actually grew about three percentage points throughout that period of time during the pandemic. I think that’s pretty exceptional myself. Overall collections – they decreased by about 1.9%. We all know about the eviction moratoriums and non-payment. Of course, some people obviously in distress, and before government stimulus was really flowing… My class A properties in the portfolio only had a decrease in collections about 0.1%; it was actually a little bit higher than that, but super low, super low.
And here’s what stood out to me – the Class B properties, they decreased almost 6% in terms of collections. So it goes to show, again, location and tenant demographic, and what are the results on paper? So are you perhaps taking a little less risk in a class A or a newer property? Possibly. Obviously, it has a lot to do with the execution of the business plan, the operator you’re working with, and so many other factors… But generally speaking about location and class, I would probably say yes.
So we have to consider the odds; investing in real estate at the end of the day is all about playing the odds. So we’ve talked about the odds of having a tenant damage your property in a lower rent environment, in a lower class of property are higher than that of a prime location with $3,000 a month rents, for example. The odds of having a tenant that’s had an eviction or that you may have to evict – that goes higher up in the lower class properties. We talked a little bit about crime. And to me, it’s just been my own perspective and experience, but I’m sure you could look up stats and facts all day on this. but there’s more crime in lower rent-paying areas and lower-class properties.
But again, in fairness, I shared the good story about a Class C, and the others are kind of yet to be determined. So hopefully, in a future episode, I can share some more insights on this. But I don’t do a lot of Class C investing. But again, I don’t want to discourage anybody from looking at Class C, or maybe you found an amazing off-market deal and it’s a Class C, or maybe it’s a Class C in a Class A area, and a value-add plan, with an experienced operator… I’m not saying Class C is bad, by any means. I just am pointing out that there’s different risk profiles that you should definitely consider if you’re going to go into the higher risk, higher reward business plans and strategies.
Alright, so to my final conclusion with telling you guys all this and sharing this data, and these stats and facts, is this – I would argue that many Class A investments could yield a similar cash flow to class C. If, for example, you were to invest in 10 Class A deals and 10 Class C deals, I would be willing to bet that overall, you’re going to have some winners and losers on each side of this. But I would bet that your average return or your overall return or your cash-on-cash return comes in pretty equal.
So the question is, how much additional risk do you want to take with the Class C? And do you want to take on that additional risk, is really what I should say, at the end of the day?
And I like to draw the parallel to the stock market, because a lot of people are so familiar with stocks, bonds and mutual funds. So think of it like this – you can invest in a stock, and it has a 6% annualized dividend that they distribute out. Or you could invest in a bond that has a 2% cash flow that it pays out. But the bond is going to be a less risky in most cases strategy or investment compared to the stock; there’s lower volatility that’s associated with it, etc. So again, what if you bought a 6% dividend-paying stock, but it fell in value over the next year? That’s the risk profile. You might end up overall with a 2% return anyway.
So the bottom line is, if you’re looking for stable, consistent cash flow in your portfolio, you need to be aware of these different risks. And you need to evaluate that portfolio-wide for yourself, or with the help of a financial advisor, which I am not, and I am never telling anybody what they should do, and I’m not licensed to do that. So seek licensed advice if that’s something that you need.
Stability comes from evaluating risk. So trust, but verify when you’re looking at these investment pro formas and overviews. I’ve talked many times about, I subscribe to the underpromise and overdeliver. I do the same thing when I make an investment. I look at what the pro forma projections are, and then I knock those down several points and I say, “Hopefully I’ll get this return. If I do, I’ll be happy.”
So hopefully, you guys found some value in this episode. I hope I covered that adequately enough for your standards. So if you ever have any questions or suggestions, email me, travis@ashcroftcapital.com. And as always, thank you guys so much for tuning in and listening. This is The Actively Passive Show. I’m your host, Travis Watts. You guys have a best ever week, we’ll see you next time.
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