What is Effective Gross Income?
Effective gross income (EGI), is all the income generated by a property, including rent, tenant reimbursements, and income from sources such as vending machines, laundry machines, and late fees. It can also be defined as a property’s potential gross income, after expenses such as vacancies and credit costs have been subtracted. EGI is an efficient way to estimate a property’s value and cash flow. In this article, we’ll break down the elements of effective gross income and look deeper into how it’s used in commercial real estate finance.
The Effective Gross Income Formula
As we just mentioned, the formula for effective gross income (EGI) is:
Gross Potential Rent + Other Income - Vacancies - Credit Loss - Loss to Lease = Effective Gross Income
Gross Potential Rent: Gross Potential Rent, or GPR, is the maximum amount of rental income a property could generate at market rent, given it has 100% occupancy. For example, if an apartment building had 10 units, each with a market rent of $2,500/month, the building would have an monthly GPR of $25,000, and an annual GPR of $300,000.
Other Income: This typically includes vending machines, laundry machines, parking spot rental, storage, pet fees, and late fees for multifamily properties. It is more likely to include only vending machine income, parking spot rental, and late fees for other commercial property types (i.e. retail, office properties).
Vacancies: As not all of a multifamily or commercial building will be occupied at all times, it’s essential to calculate for vacancy when using the formula. The average vacancy rate for traditional commercial or multifamily properties is 7%, while it’s typically much greater for specialized commercial property types (i.e. hotel, self-storage). For instance, in 2018, the average hotel vacancy rate was nearly 34%. However, from a real estate investing standpoint, this only matters if the hotel property is owner-occupied— in the case that a hotel company was leasing the building from a property owner, the owner would consider the building fully occupied, no matter the hotel’s actual vacancy rate. Vacancy rates can also impact other sources of income, especially for multifamily properties that are using RUBS income for their utility payments.
Credit loss: Credit loss occurs when a tenant is occupying a property, or a unit of a property, but is not paying rent, or is not paying fully. Unfortunately for landlords, state and local eviction laws must be followed, so it can sometimes take 60-90 days (or even more) to legally evict someone from a property. A tenant that occupies a unit but does not pay rent is also sometimes referred to as an economic vacancy.
Loss to lease: Some EGI calculations also include loss to lease, which refers to the income a landlord loses when they offer financial incentives to a tenant in order to induce them to sign a lease. This is most common in multifamily properties and senior housing, and often comes in the form of one free month of rent for signing a 6-12 month lease, or as a small monthly rental discount over that same period.
Other Factors That May Affect EGI
Downtime: Downtime is the cost of having unoccupied rental units, and is usually used in situations where a property is undergoing rehabilitation for a specific time period. When property is unoccupied for other reasons, it is usually classified as physical vacancy.
Turnover: Finally, turnover is another cost that commercial property investors should be aware of. Turnover generally refers to any costs of making a unit ready for the next tenant, but does not include major upgrades or minor repairs and maintenance, which are usually part of a unit’s tenant specific allowance. While sometimes counted against a property’s EGI, turnover is more commonly counted as part of a property’s operational expenditures.
Simple vs. Detailed EGI Calculations
In general, effective gross income can be calculated in one of two ways. A simple EGI calculation would only involve taking rental income, adding other income, and subtracting the property’s vacancy. In contrast, a complex EGI calculation would involve more of the factors mentioned above, and would take potential market rental income and subtract loss to lease, vacancy, and credit loss, while adding any other income generated by the property.
For instance, if we use the numbers from the gross potential rent example early in this article, assuming the vacancy was 7% (the national average), and that the property generated $2,000 a month in other income ($24,000/year), we could do a simple EGI calculation like so:
$300,000 + $24,000 - $21,000 = $303,000
However, if we use a more complex calculation, we might factor in a credit loss of 2% of rent ($6,000) and a loss to lease of $12,000 (for instance, if the owner gave 5 out of the 10 tenants one month of free rent). This EGI calculation would end up looking slightly different:
$300,000 + $24,000 - $21,000 - $6,000 - $12,000 = $285,000
So, while using the complex calculation is certainly a more exact way to estimate the EGI of a commercial property, both methods are an excellent tool that investors can use to determine whether a property can truly be profitable.