We came across this article which appeared this past summer in “Multi Family Executive”. It does a nice job of making the argument as to why Class B/C apartments are turning out to be better investments than the Class A properties which are getting all the headlines!
This has been a theme that resonates with Prudent Growth Partners. We believe that B/C properties – which tend to be smaller and which tend to trade at a higher cap-rate (typically 7.25 to 7.75) represent a superior investment to larger, lower cap-rate class A properties.
This is true for several reasons:
1 – There is less new inventory being built in the B/C market – almost all new construction occurring in the markets tracked by PGP is priced at $150,000 per unit and above. Class A properties are simply more profitable for builders and developers, and that dynamic is unlikely to change. Furthermore, the deteriorating condition of some B/C apartments - particularly in the urban core - actually means that the inventory of available units is actually shrinking.
2 – There is a growing population of B/C renters. As the economy continues to crawl its way along with 2.0% to 2.5% annual growth, the number of renters who need more affordably-priced apartments is growing – and supply is not keeping up with them.
3 – Financing for B/C properties has been getting easier, and loan rates and terms are within striking distance to the traditional, larger sized class A loans.
4 – Well maintained properties – with rapid maintenance response, attractive landscaping, and high tech efficiencies (websites, online maintenance requests, online rent payment options, etc.) will stay well occupied, with lower turnover and higher tenant satisfaction.
From the article:
Most households living in B/C apartments are doing so out of necessity, not preference. If they could afford something better, they’d likely choose it. However, with median real household income falling over the past two decades, many households have limited ability to spend on goods and services, especially housing. This situation relegates them to B/C apartments and essentially excludes these households from purchasing a home. That’s especially true these days, with residential mortgage underwriting standards remaining so stringent. Indeed, it’s tremendously difficult for many households to obtain a mortgage, even an FHA loan. Although FHA loans are ideal for lower-income households, many of these households have impaired credit that puts even this option out of reach.
With the majority of the pipeline focused on Class A, there's little to no competition from new Class B or C apartments. In fact, in recent years, Class B/C inventory has actually been declining, due to conversions, demolitions, etc., which are not adequately being replaced by either new construction or Class A properties sliding down into the B/C category. This presents an ample opportunity for Class B/C rent growth to accelerate.
Although apartment rent growth is surely constrained by income growth, household incomes are projected to keep growing, which will enable B/C landlords to continue to increase rents. Meanwhile, Class A rent growth will slow and compress toward the inflation rate, weighed down by all the new competition in the market. Additionally, the lack of new competition in the B/C space will continue to put downward pressure on an already incredibly low vacancy rate.
The Class B/C vacancy rate is now 220 basis points lower than Class A’s. This wasn’t always the case, but the hundreds of thousands of new Class A units that have been added over the past few years have pushed Class A vacancy well above Class B/C’s. Therefore, it’s highly likely that NOI growth for Class B/C properties will exceed that for Class A properties over the medium term.
Beyond the fundamentals, there’s also a capital markets argument for B/C investment. Class B/C properties typically trade at a discount to Class A properties. On the cap rate side, the discount is currently equivalent to about 100 basis points. And while higher cap rates usually reflect greater risk or worse NOI growth prospects, that doesn’t look to be the case now.
Obviously, each property will differ, but from a macro perspective, at the moment there appear to be more risks associated with Class A than with B/C, and Class A is likely to have slower NOI growth than Class B/C.
Full Article here: http://www.multifamilyexecutive.com/business-finance/class-b-offers-choice-investments_o