Why Class A Apartments?

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As a real estate investor, I get a lot of questions about what we do and how we do it. Probably the most common question I get is why do we invest in Class A apartments? Behind that question are the questions of “where is the upside?” and “isn’t it risky to charge so much rent?” Let me deal first with the upside question.

What’s the upside?

Most believe that the only way you can get an “upside” is by brick-and-mortar renovations. This is your classic value-add scenario; add granite countertops, paint the walls, and change the light fixtures and then increase rents. This does work. We do it all the time. However, this is not the only way to add value.

Many Class A deals are running “fatter” than they should and there is an upside to organic rent growth and operational efficiencies. These upsides can be achieved without spending capital, as in the classic value-add scenario.

The other factor to consider in the current market is that your typical value-add deals have a lower cap rate than your core, Class A deals. You are paying a premium for the upside. Therefore, the choice becomes do we buy a value-add deal at a 3.8% cap  that requires a lot of capital, work, and risk that the business plan is not executable, or do we buy a Class A deal that is stabilized and cash flowing for a 4.2% cap?

The other thing to consider is time. A value-add deal will take much longer to achieve the proforma numbers because we must physically renovate all the units to do so. This can take up to two years, depending on the number of units on the property. Whereas on a Class A deal we can implement the changes immediately and can achieve proforma rents within 12 months or less, depending on lease expiration schedules.

Does this mean that we do not like value-add deals anymore? No, we still love value-add deals. We still underwrite many value-add deals each year. However, we tend to look for properties with a lighter value-add and a lower rental increase. If we only have to add a ceiling fan and some light fixtures and paint the walls, we can do that as a normal turn and not delay the next resident from moving in. Or the value-add might be in the amenities, which does not affect vacancy under normal circumstances.

Affordability of Class A

Now let’s discuss rental rates and/or affordability of Class A apartments. The thought process tends to be that if we charged rent that was more affordable for more people, then it would be less risky. This is simply not the case.

In a recent article for the Multifamily Executive Magazine, Jay Parsons, a multifamily economist with Real Page, wrote the following…

The median market-rate apartment household pays 21% of its income toward rent. This statistic comes directly from property managers’ rent rolls, extracted by MPF Research from the millions of units serviced by RealPage software. The publicly traded REITs have all reported similar numbers, ranging from the high teens to the low 20s. That’s nowhere near the unaffordability threshold, which most economists pin at 30%.

But the rent-to-income number alone doesn’t tell the full story. It’s important to also look at retention rates. Are rising rents leading to more vacancies? No; vacancy levels are near record lows. Are rising rents forcing renters to move out in big numbers? Again, no; the daily rent roll data on millions of units tracked by MPF show that retention rates are actually climbing. In 2015, 52% of renters with expiring leases signed renewals. That’s unusually high, and it’s up 80 basis points year over year. Retention rates have now increased in five of the past six years, in fact. Additionally, the public REITs are reporting declines in unpaid rent.

Given these facts, how has the narrative of a runaway affordability crisis become a widely held belief—a topic mentioned at every industry event and every CNBC interview with a real estate economist? To answer that question, let’s look at the math.

In a posting on LinkedIn, Parsons wrote…

Another fascinating finding from our study on apartment affordability: The more expensive the rent, the lower the rent-to-income ratio. Renters in Class A+ apartments spend the lowest share of income on rent, while Class C-/D renters spend the highest share.

RealPage studied renter incomes and affordability by asset class, which is generally correlated with rent level. The median rent-to-income ratio in Class A+ properties (generally newest and priciest units) was just 19.4% in 2020thanks to median incomes of $92,000. In Class B apartments (more average), the median renter made $57,780 in income and spent 21.7% toward rent.

On the flip side, renters in the cheapest apartments tend to spend the highest percentage of income on rent. Median rent-to-income ratios came in at 25.5% in Class C- and 27.0% in Class D properties (generally older and lower-rent units). Renter households in those segments had incomes below $35,000.

Affordability trends align with rent growth trends over the last decade. In Class C units, rents increased at an average annual rate of 2.35% nationally. By comparison, rents increased 3.19% on average in Class A and 3.25% in Class B.

So why class A apartments?

To start they have great curb appeal. They are shiny and new, and they provide an investment that you are proud to tell your friends that you own a part of the property.

Also, because the units are newer, better maintained, and are many times under warranty, this allows for fewer unknown expenses that may be found after we take ownership of the deal. Finally, our residents are more financially able to navigate downturns in the overall economy as they are spending less of their total income on rents. The residents tend to be people who desire to live in an apartment due to the simple quality of life that it provides for them.

And let’s not forget one of my favorite reasons; we at PassiveInvesting.com are always looking for the most stable way to place investor capital. Class A apartments meet and exceed those standards in more ways than ever before.