Smart property buyers want an A, not a C grade

You’ve probably heard this before: if you want to beat the market’s growth rate, stick to A-grade properties as they always perform best.

Is this true? And what is A-grade anyway and how can you tell if the property you’re looking at is A-grade, B-grade or C-grade?

What is A-grade real estate?

Thirty years ago, the terms A, B or C grade were just catching on and it’s taken up to now for buyers to start asking agents about them.

A-grade property and investment-grade are different but related concepts – but we’ll come back to this.

Generally speaking, agents refer to A-grade properties as those having high emotional appeal because they are in a great location and don’t have any compromises.

B-grade properties are seen as an otherwise A-grade, with one significant compromise or a few small compromises.

But a C-grade property has multiple significant compromises affecting its appeal.

What do we mean by compromises?

Compromises can be an ambiguous term but the way I think of it is something that will put off relevant buyer types for this property.

Some of the more obvious compromises are location, build quality, position and floor plan.

Location seems pretty obvious but it’s also a term with different meanings.

Let’s think about some often-mentioned great areas for property over the last decade, like Kedron in Brisbane, Brunswick East in Melbourne or Annandale in Sydney.

These are great inner suburban locations, but a property on a busy road or has neighbouring light industry fails the A-grade test. Similarly, investors need to consider how the property is positioned: is it far enough away from traffic noise and other uses which would interfere with quiet, amenable living?

But positioning goes beyond this and includes how a property is positioned on the street and how the building is located on its block.

If a house sits on top of a rise in the street that improves its view, that is certainly a positive. But if its position on the block leaves it too close to a neighbouring property, that can affect its outlook and privacy.

As an investor, you’re aiming to buy a property that doesn’t have anything to detract from the quality of life offered or saps buyer appeal on auction day.

The property itself

Moving past location and position, there are other compromises to look out for.

Inferior build quality is a serious factor that should count investors out of the bidding and give home buyers serious pause due to the expense of rectifying such issues.

A floor plan that doesn’t deliver open plan living is another but assessing layouts requires a little more thought. For example, small bedrooms in suburban or regional houses are a definite no-no but may be okay in inner suburban apartments.

The same applies to aspect. You always want a property to deliver a pleasant outlook and plenty of natural light inside but the necessity of this for a family home in a prestige suburb than a townhouse within walking distance of the CBD when it comes to assessing value.

Working out if a property is A-grade

Given the way the pricing for Australian real estate works, strong demand for not enough properties sees most of the value uplift accumulate in the land price.

That means A-grade properties are characterised by a property with a high land value as a proportion of the overall price.

For A-grade houses in major metro markets, that typically equates to land value of around 65 to 75 per cent of its overall price. That can be difficult to assess as land values and building costs shift and swing, so investors should seek expert advice.

Similarly, for A-grade units in the suburbs of major cities, the notional land value should make up around 45 to 60 per cent of the property’s price.

With B-grade properties, the test is whether you can economically fix a glaring compromise and turn your purchase into an A-grade property.

For C-grade properties, its compromises can’t be fixed. No matter what an owner does, they can’t change the volume of traffic going past the door or the train line over the road.

A similar impact is true for newly built units and house and land packages.

Because these developments need to provide a sufficient return for the builder and have been designed to maximise tax breaks, it can take up to a decade for the land value equation to add up; and that will only be in the best opportunities.

How different properties move through the cycle

In classic theory, real estate prices move through what’s called the property cycle.

In this model, values fall, then dawdle for a period before accelerating, moving into a boom before being checked as too many buyers find themselves priced out.

The classic property cycle looks like this model below, although Australians should note, we haven’t seen a genuine property recession since the early 1990s, resulting in our S-shaped graph mostly moving upwards.

C-grade properties struggle throughout the cycle except at the pinnacle of a strong boom, where more buyers struggling to get into the market find that the only homes they can afford have significant compromises.

A-grade properties tend to do the best across the rest of the cycle, followed by B-grade.

Tend to do best, but not always. Even outstanding A-grade properties can get caught out in a downward or stagnant part of the cycle.

This is where the difference between A-grade and investment-grade comes to the fore. Because investment-grade assets are being sought by several types of homebuyers and investors, their prices are more immune to downturns and are the first to rise during a recovery.

Some A-grade properties – think expensive family homes, properties in coastal resorts and prestige apartments – need a buoyant market to return before their performance starts beating the market, due to their limited pool of buyers.

So, if you’re out hunting for an investment, limit your search to A or B-grade properties – then be ruthless in eliminating those that don’t make the investment-grade mark.