The (Other) Golden Ratio
This article is about the Golden Ratio. You may have heard about the Golden Ratio in mathematics and architecture, but that’s not what I’m going to talk about. I’m going to talk about the other Golden Ratio — the one that applies to apartment investments. You probably won’t see it referred to as this anywhere else, but this is what I call it in this blog (because it’s worth so much).
The Golden Ratio in apartment investing is about 10 to 1 (10:1). This is the ratio between the amount of extra value you get out of your apartment investment for every extra dollar of income your property brings in.
In other words, for every $1 of extra income your property produces, the value of your property increases $10! Let’s take a look at why that’s the case:
If you remember from our Financial Analysis tutorial, the price of an income producing property is directly proportional to the amount of net operating income (NOI) it produces:
Price = NOI / Cap Rate
(This is just a rearrangement of the Cap Rate formula: Cap Rate = NOI / Price)
So, if a typical property has a cap rate of about 10% (which is a pretty realistic average), then for every $1 of NOI the property generates, the property is worth $10.
For example, let’s say a property with a cap rate of 10% has an annual NOI of $1000; using the formula above, the property is worth about $10,000 (Price = $1000 / 10% = $10,000). Now let’s say that same property is able to increase its annual NOI to $1100; now its price increases to $11,000 (Price = $1100 / 10% = $11,000). That extra $100 in income translates to an extra $1000 in property value (a 10:1 increase).
And remember, when we talk about NOI, we’re talking about the total income after expenses. So, for every $1 you can shave off expenses, you get the same $10 increase in property value. For example, if you can cut your annual property taxes by $500, your property value will have just increased $5000.
Pretty cool, huh?
While it should now be obvious why investing in apartments can be so lucrative, I’ll spend some future posts going into detail about how to really leverage this Golden Ratio.