Real Estate Asset Classes: Everything You Need To Know To Reduce Risk In Your Portfolio

Investing in Real Estate Private Equity can be a great solution to quickly invest in all types of commercial real estate asset classes from multi-family apartment complexes to medical, office, self-storage and of course, non-commercial single-family houses while letting someone else handle all the details. 

This post is a continuation in the series on Investing in Real Estate Private Equity, a guide to Real Estate Partnerships, Real Estate Private Equity Funds, Syndicates & Crowdfunding. In our last post, what Types of Real Estate Can You Invest In, we discussed the various commercial real estate categories as well as advantages and disadvantage of each asset type. Here we are going to dig deeper into the different types of real estate and specifically how they can help you diversify to lower your overall risk.

Diversifying with real estate asset classes is a smart investment strategy that can help reduce risk and increase potential returns. These diversification techniques is why I love to invest using real estate private equity funds, since it allows me to really spread out my investments, by asset type, asset class, geographic location as well as deal size. Let’s learn how we can diversify with real estate asset classes …

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What are Real Estate Asset Classes?

Within each type of real estate there are different quality levels or “classes” from investing in a Motel 6 to investing in a much higher-end hotel like a Ritz Carlton.  The most common classes are A, B and C and each carries various advantages and disadvantages. Knowing the difference and using this to diversify within each real estate asset class will help to lower your investment risk.

Class A, B, and C are designations used to categorize commercial buildings based on their age, location, and quality. The distinctions between these classes are not standardized, and they can vary based on the local real estate market. However, here are some general characteristics that are associated with each class:

Asset Class A

• These buildings are newer or recently renovated with modern design and features.
• They are located in prime locations with easy access to amenities such as transportation, dining, and shopping.
• They have high-end finishes and amenities, such as top-of-the-line HVAC systems, elevators, and security features.
• They have high rents and attract high-quality tenants, such as large corporations, law firms, and financial institutions.

Asset Class B

• These buildings are older than Class A buildings and may require some renovations or upgrades.
• They are located in good locations, but not in the most prime locations.
• They have standard finishes and amenities, such as basic HVAC systems and elevators.
• They have lower rents than Class A buildings and attract smaller businesses, startups, and non-profits.

Asset Class C

• These buildings are the oldest and may have outdated design and features.
• They are located in less desirable locations with limited access to amenities.
• They have basic finishes and amenities, such as window air conditioning units and no elevators.
• They have lower rents than Class B buildings and attract small businesses, startups, and budget-conscious tenants.

In summary, Class A buildings are the newest and highest quality, Class B buildings are of a medium quality, and Class C buildings are the oldest and lowest quality. But, when looking to lower investment risk, diversifying through real estate asset class has many benefits.

Advantages and Disadvantages of Each Asset Class

When looking at the different real estate asset classes, there are advantages and disadvantages of each.

Class A Advantages and Disadvantages

Class A buildings are typically newer, located in prime locations, and have high-quality finishes and amenities. These factors make them highly desirable to tenants, which means they are likely to have stable and reliable rental income. As a result, Class A buildings are generally considered the least risky of the three classes.

Class A Advantages:

• High-quality buildings with modern design and features.
• Located in prime locations with easy access to amenities and transportation.
• Attract high-quality tenants, which can provide stable and reliable rental income.
• Typically have longer lease terms, which provide stability for investors.

Class A Disadvantages

• High purchase prices and rents, which can limit the pool of potential investors and tenants.
• Higher operating expenses due to the high-end finishes and amenities.
• More competition from other investors seeking to acquire Class A buildings.

Class B Advantages and Disadvantages

Class B buildings are usually older than Class A buildings. As a result, they may require some renovations or upgrades. Class B’s are located in good but not prime locations. They attract a more diverse range of tenants. Although Class B buildings offer slightly more risk than Class A buildings, they still have relatively stable rental income.

Class B Advantages

• Lower purchase prices and rents, which may be more affordable for investors and tenants.
• Attract a diverse range of tenants, including small businesses and startups.
• Typically have shorter lease terms, which can allow for more frequent rent increases.

Class B Disadvantages

• May require renovations or upgrades to attract quality tenants.
• Located in less prime locations compared to Class A buildings.
• May have less stable rental income due to turnover among smaller tenants.

Class C Advantages and Disadvantages

Class C buildings are the oldest and often located in less desirable locations with limited access to amenities. They require significant renovations or upgrades to attract tenants and often have lower credit quality tenants,which increases the risk of rent payment defaults. As a result, Class C buildings are considered the most risky of the three classes.

Class C Advantages

• Lower purchase prices and rents, which may be more affordable for investors and tenants.
• Lower operating expenses due to the basic finishes and amenities.
• Opportunity for investors to add value through renovations or upgrades.

Class C Disadvantages

• Located in less desirable locations with limited access to amenities and transportation.
• Require significant renovations or upgrades to attract tenants.
• Attract tenants with lower credit quality, which can increase the risk of rent payment defaults.

Which Asset Class is the Best?

The advantages and disadvantages of each class will depend on the individual investor’s goals, risk tolerance, and investment strategy. Risk will vary greatly based on individual factors such as the local real estate market and the condition of the property. In my opinion, there really isn’t one right or wrong real estate investment type. Each has its benefits and drawbacks and all serve a specific niche market.

Diversification is the Key

I personally prefer using a broad spectrum of real estate types and classes to achieve good diversification in my portfolio.  But, of course, these decisions should be personal, dependent on each person’s investment goals. For me, capital preservation is paramount and as a result, I’d much prefer 20 smaller well diversified investments vs one large one. While Class A buildings offer the highest quality and stable rental income, they are more expensive and have more competition. On the other hand, Class C buildings offers more potential for value-add opportunities, but also have a higher risk of rent payment defaults.

Real estate asset classes is an important factor to consider when determining which investments are best for your portfolio. Most importantly, diversifying across multiple asset classes will help to reduce your overall risk.

A major factor in choosing which asset class to invest in should revolve around where we are in the Economic Cycle. In our next post, we dig deeper into Real Estate Diversification by looking into these cycles and how each asset class above is affected.

What are your thoughts on Real Estate Asset Classes? Which is your favorite?