The (Other) Golden Ratio

May 30, 2008 · 2 comments

This post 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.


2 responses to “The (Other) Golden Ratio”

  1. Andres says:

    This is a great point.
    Something I’ve been noticing lately is that cap rates are trending lower, well below 10%. I’m seeing cap rates tending more toward 6-8% in the areas I’m looking at.
    I understand that each area is different though.
    What are the cap rates in general for the Atlanta area? (I don’t mean to put you in the spot, just asking :D)

  2. J Scott says:

    I haven’t quite figured out the cap rates in this area yet. Certainly there are larger properties downtown that are seeing cap rates in the 6-7% range, but I’m hoping to buy somewhere outside the city, and it appears cap rates are all over the place depending on the specific local area.

    Atlanta is a huge metro area, so there are parts that are growing rapidly (and seeing lower cap rates) and parts that aren’t growing very fast (and where you can still find properties with a 11-12% cap rate).

    One of my goals for the coming weeks is to start driving around and getting familiar with the local areas.

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