Class B Offers Apartment Investors the Best Balance

Article originally posted on Globe St. on December 14, 2023

Trophy assets might not provide the optimal investment return, given the commotion of the past several years. Instead, Berkadia suggests giving more consideration to Class B.

Whether due to its luster wearing off or its leveraged returns have the least cushion to withstand higher interest rates, Class A’s pricing premium has eroded to just 32 basis points and 42 basis points versus Class B and Class C properties, respectively,” according to a new report from Berkadia.

Class A has been particularly sensitive to changes in the underlying market during the past three and a half years. Its best performance occurred when the market was most supportive, but it returned relatively lackluster results when the market was under pressure – exhibiting the most systematic risk, Berkadia said.

This was shown to flow from rents being relatively susceptible to deliveries exceeding net absorption and flowed down through property income. This is due to Class A having to compete with the latest deliveries, unlike Class C, Berkadia presumes.

On the other hand, Class C shows the most property level uncertainty due to its higher and more unpredictable operating expenses, according to the firm.

Making a “rational” investment choice thus becomes a function of expectations and portfolio size, Berkadia said.

“Investors who are bullish on rental market fundamentals or who expect the basis in cap rates to revert to historical norms may favor Class A,” according to the report.

“Conversely, those less optimistic about the rental market solidifying its strong position versus single-family in the face of higher interest rates, or who fear an upcoming recession, may choose Class C – especially if they have a large enough portfolio to diversify away its expense volatility.”

Class B, therefore, likely has the best balance, Berkadia said, especially for investors who don’t currently carry a strong viewpoint.

After all, “Class B provides insulation from both Class A’s sensitivity to new deliveries and Class C’s tenant delinquency issues and property-level volatility,” Berkadia said.

Furthermore, during the past three and a half years, Class B provided the best cumulative performance measured by top-line rents and bottom-line net cash flow.