The multifamily real estate market, in general, has occasionally lost sight of downmarket properties as we fixate on big, bright, shiny new towers.

But as enticing as high-end real estate is — not just to live in, but also to brag that you own a piece of — it’s not the whole story. We do a disservice to the broader population and, not inconsequentially, our investors if we don’t at least study how we could make as much if not more money from rehabbing existing housing stock.

The ABCs of Multifamily Real Estate

First, let’s make sure we’re all defining the classes of multifamily real estate the same way. While Seeking Alpha offers a good nutshell on the topic and Realty Moguls provides a slightly deeper dive, the best description we’ve seen of multifamily real estate’s class distinctions comes from the Commercial Real Estate Finance Company of America. Not to be lazy, but maybe it’s best just to capture CREFCOA’s bullet points verbatim:

Class A Multifamily

• Generally, a garden product built within the last 10 years
• Properties with a physical age greater than 10 years but have been substantially renovated
• High-rise product in select Central Business District may be over 20 years old
• Commands rents within the range of Class “A” rents in the submarket
• Well merchandised with landscaping, attractive rental office and/or club building
• High-end exterior and interior amenities as dictated by other Class “A” products in the market
• High-quality construction with the highest quality materials

Class B Multifamily

• Generally, a product built within the last 20 years
• The exterior and interior amenity package is dated and less than what is offered by properties in the high end of the market
• Good quality construction with little deferred maintenance
• Commands rents within the range of Class “B” rents in the submarket

Class C Multifamily

• Generally, a product built within the last 30 years
• Limited, dated exterior and interior amenity package
• Improvements show some age and deferred maintenance
• Commands rents below Class “B” rents in the submarket
• Majority of appliances are “original”

Class D Multifamily

• Generally, product over 30 years old, worn properties, operationally more transient, situated in fringe or mediocre locations
• Shorter remaining economic lives for the system components
• No amenity package offered
• Marginal construction quality and condition
• The lower side of the market unit rent range, coupled with intensive use of the property (turnover and density of use) combine to constrain budget for operations

According to Seeking Alpha, the rents you can expect from these classes vary as you go through the alphabet.

“Class A apartments in the nation’s one-hundred largest metros rented for $1,663 on average in January 2017, while rent for the average Class C ran $850,” the article reports.

But just because you’re getting paid twice as much for a Class A as opposed to a Class C, that doesn’t mean that it’s twice as profitable from an income statement perspective. And, from a capital investment perspective, the returns from a 20-year-old garden apartment complex with a new coat of paint could even exceed that of a new glass tower with lemon water in the lobby.

The Advantages of Workforce Housing Stock

No need to read the whole Harvard study on the current state of America’s housing. There won’t be a quiz. The important takeaway is this: As a nation, we added more than 1.2 million new units in 2018, and it’s not enough. The vacancy rate keeps falling, with the most recent nationwide reading at 4.4%.

“Meanwhile, the housing that is being built is intended primarily for the higher end of the market,” the study says. “The relative lack of smaller, more affordable new homes suggests that the rising costs of labor, land, and materials make it unprofitable to build for the middle market. By restricting the supply of land available for higher-density development, regulatory constraints and not-in-my-backyard (NIMBY) opposition may also add to the challenges of supplying more affordable types of housing.”

So there’s a serious unmet need for Class B-and-below housing.

Although a management company can’t get Class A rent from Class B apartments, the amount required to invest will likely be far less. Rather than breaking ground on greenfield construction — which is getting more expensive all the time — may be all that’s needed after a comparably low-cost acquisition is refurbished kitchens and baths, new HVAC systems and more contemporary signage.

“The modest returns of a Class A property with single-digit to low-teen internal rate of return (IRR) just isn’t enough when compared to the high-teen IRR results obtained when value-add is completed on Class B and C properties,” according to Blue Lake Capital CEO Ellie Perlman.

And let’s not forget that rents are a moving target, and it so happens that Class B rents are moving far faster than Class A rents. According to a rather data-intensive report from Bridge Investment Group, the investment case for Class B projects just keeps getting better when you factor in how much more rents in this class increase over the life of the asset when compared with Class A.

A Word of Caution

We’ve been largely silent about Class C and D so far, but that’s not because it’s necessarily a bad investment or even unpalatable from a renter’s or public advocate’s perspective. There will always be a need for low-end housing most obviously because there will always be poor people, but also because there will also be people who choose not to spend too much on rent at a given juncture in their lives. Maybe they’re new in town and are looking for a permanent place, or maybe they’re working on a six-month contract and $500 a month for a furnished studio near the job site is all they’re looking for.

These classes, though, are a bit off the beam of what Sharestates investors are looking for.

“Class C and D assets tend to be financed by local banks with little to no interest from secondary market lenders, according to CREFCOA, which warns investors to expect higher interest rates, shorter loan terms, lower leverage, and even personal recourse if the project fails.

Even with Class B, though, you might not get the same leverage or fixed-rate terms as you would with a Class A investment. And if your Class B project stands outside a major market, you might even get pushback about using the property as collateral and need to provide a personal guarantee.

It’s not Slumlording

Lumped together, these three less glamorous classes are often called “workforce housing” or “affordable housing,” and they serve an important social function. Not everyone can afford Class A and not everyone who can afford it sees the value of spending money on four walls that, during waking hours, they’re only going to shower and watch Jimmy Fallon at.

And while we’ve gone on about the opportunities to make a profit from refurbishing an old property, there’s really no need to do even that. Affordable housing advocates point out that these value-adds that move a Class C up to a Class B or a Class B to a Class B+ or A- have the effect of pricing potential renters out of the low end. Beyond merely maintaining the pipes and mowing the grass, low-end properties can serve as essentially passive investments.

Still, real estate investment is an imperfect market. Locations aren’t nearly as fungible as securities or mutual funds. Moreover, nobody on Wall Street ever had to be cautioned, “Don’t fall in love with a debenture.” It’s just human nature to want to be associated with a skyline-defining work of modern architecture than with a lump of poured concrete that dates predates America Online.

“With most new construction targeting the high end of the market, there have been some potential for excess supply to filter down to lower rent levels,” according to the Harvard study. “But with rental demand far outpacing additions to supply through 2016, this has not happened.”

So there’s a lot of pent-up demand for workforce housing. To meet it in a financially rewarding way, it just requires some investors to peer out of their ivory towers long enough to notice that not everybody lives in one themselves, or even want to.