What Is Effective Gross Income?
Effective gross income is an investment property’s potential rental income along with any other sources of income, minus any vacancy, credit, and collection losses.
When looking at rental properties as potential investments, it is important to focus not only on the obvious factors such as the asset’s location and class, but the numbers behind the property as well — and we’re not simply talking property values. Multifamily investors and lenders alike rely on many different metrics in order to get a clearer picture of the financial strengths of a rental property. One metric that is of particular interest concerning the value of an investment property is effective gross income, or EGI.
Effective gross income measures the potential total revenue of an asset. More specifically, effective gross income is defined as the sum of an asset’s collected rent and other income sources, less vacancy costs and credit losses. EGI is an important factor in determining a property’s value, as it best represents the asset’s true positive cash flow.
Calculating Effective Gross Income
In order to determine effective gross income, the property’s gross potential income, or GPI — sometimes called gross potential rental income (GPRI) — must be calculated first. With that value in hand, any additional income generated by the property must be factored into the equation as well. This typically includes income from vending machines, paid parking spaces, storage units, pet fees, or other similar sources.
The next metrics to be determined are the vacancy and credit costs. Unlike with GPRI, which assumes zero vacancies and all rents paid in full each month, effective gross income accounts for the more realistic issues of vacancies and credit disruptions that most property owners find unavoidable. Even so, these metrics are hypothetical estimations based on historical data — after all, no one can actually predict the future. In most cases, these figures are determined utilizing any available industry, market, and historical data of relevance.
Once you have determined all of the aforementioned figures, the EGI formula is straightforward. Effective gross income is typically representative of annual revenues, so all of its components should be calculated on an annual basis as well.
The Effective Gross Income Formula
EGI = Rental GPI + Other income - Vacancy and credit costs
An Example of an EGI Calculation
Need an example to bring the math to life? Imagine a property with 12 units. Each unit has a market rent of $5,000 per month. That’s equivalent to a monthly GPI of $60,000, or an annual GPI of $720,000. Additionally, the property has on-site laundry machines, rentable storage spaces, pet fees, and vending machines which generate $7,000 in total. Finally, based on some historical data of the property and your personal knowledge of the rental market in your area, you can safely assume vacancy and credit costs of roughly $50,000 per year. Thus, the calculation would be:
EGI = $720,000 + $7,000 - $50,000
EGI = $677,000
And there you have it. The 12-unit community’s effective gross income is $677,000.
Components Used to Calculate EGI
For further clarification, we will break down the different components of the EGI formula.
Gross Potential Income
Gross potential income, or GPI, is a calculation of the maximum amount of rental income that a landlord could generate from a property. GPI assumes that a property has 0% vacancy and that all rents are paid in full all year.
Other Sources of Income
This component of includes all non-rental income generated by the property. After all, It isn’t uncommon for property owners to have multiple revenue streams from one asset. Though the list is not exhaustive, some common items to include here are:
Parking fees
Storage unit fees
Vending machine income
Laundry machine income
Pet fees
Clubhouse rentals
Late fees
What is the definition of effective gross income?
Effective Gross Income (EGI) is a measure of a property's income potential, calculated by adding the property's Gross Potential Income (GPI) to any additional income generated by the property, such as income from vending machines, paid parking spaces, storage units, pet fees, or other similar sources, and subtracting any vacancy and credit costs. The EGI formula is typically representative of annual revenues, so all of its components should be calculated on an annual basis as well.
For more information, please see What Is Effective Gross Income? from Multifamily.Loans and GPI: Gross Potential Income from Apartment.Loans.
How is effective gross income calculated?
Effective Gross Income (EGI) is calculated by taking the property's Gross Potential Income (GPI) plus any additional income generated by the property (e.g. vending machines, paid parking spaces, storage units, pet fees, etc.) and subtracting any vacancy and credit costs. All of these figures should be calculated on an annual basis. The formula for EGI is:
EGI = Rental GPI + Other income - Vacancy and credit costs
For more information, please see Gross Potential Income (GPI).
What are the benefits of using effective gross income when financing a multifamily property?
Using effective gross income (EGI) when financing a multifamily property can be beneficial in a few ways. First, it can help investors forecast an asset's positive cash flow. This is important to know whether or not the property can generate enough positive cash flow to cover its operating expenses and turn a profit. Second, EGI is unique in its inclusion of potential losses caused by vacancies or partial payments. This makes it a useful metric when comparing between potential investments. For more information, see Early Considerations for First-Time Multifamily Investors and What Is Effective Gross Income?.
What are the risks associated with using effective gross income when financing a multifamily property?
When financing a multifamily property, one of the risks associated with using effective gross income is that it may not accurately reflect the true income potential of the property. This is because effective gross income does not take into account vacancy, concessions, bad debt, and other expenses that can reduce the net rental income of the property. Additionally, effective gross income does not take into account other sources of income such as commercial rents, parking fees, laundry and vending, late/NSF fees, application fees, storage fees, cable TV, tenant charges, and utility reimbursement. As a result, lenders may not be able to accurately assess the true income potential of the property, which could lead to a higher risk of default on the loan.
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What are the differences between effective gross income and gross operating income?
Gross Potential Income (GPI) is a metric used to determine the Effective Gross Income (EGI) of a property. GPI is the total income that a property could potentially generate, while EGI is the income that a property owner is actually earning. EGI is calculated by taking a property’s GPI and subtracting vacancies and credit loss. Vacancies are common and relatively easy to account for, while credit losses come into play when a tenant does not pay part or all of rent owed.
EGI is a common factor in the valuation and underwriting stages of commercial real estate debt transactions, as it is an important metric in the calculation of a property’s Net Operating Income (NOI) and Cap Rate. The EGI can also be used to help a lender assess the debt service coverage ratio.
Effective gross income is an essential calculation for an investor because it is used to forecast an asset’s positive cash flow. Generally speaking, it is important to know whether or not the property you are considering purchasing can generate enough positive cash flow to cover its operating expenses and turn a profit. EGI may not be the only metric used for this purpose, but it is definitely unique in its inclusion of potential losses caused by vacancies or partial payments. For this reason — despite the fact that it is more or less an estimation — many investors find it to be incredibly useful when comparing between potential investments.
How can effective gross income be used to determine the value of a multifamily property?
Effective gross income (EGI) is an important factor when it comes to determining the value of a multifamily property. EGI is the total income generated by the property, including rent, occupancy rate, and any other income sources like parking fees or laundry facilities. This is especially true of larger multifamily properties.
The Gross Rent Multiplier (GRM) metric can also be used to provide a quick, but rough idea of the value and profitability of an investment property in a specific market. GRM is calculated by dividing the price of the property by its gross rental income. This metric is mostly used to screen a market by comparing similar properties within an area.
Vacancy and Credit Losses
Easily the most complicated part of the formula, it’s essential to your EGI calculation to try to accurately forecast costs associated with vacancies or credit losses. What makes the EGI metric so valuable to investors is that unlike other similar metrics, EGI assumes that a property rarely sustains full occupancy over a one-year period and, similarly, that rent payments may not always be paid in full or on time — despite the terms of the lease.
That said, experienced commercial real estate investors can usually draw upon past knowledge of similar assets to estimate these costs. Even sans-experience, adequate estimations can be formed through the study of current and historical market reports or industry data relevant to the property and area.
The Importance of EGI
Effective gross income is an essential calculation for an investor because it is used to forecast an asset’s positive cash flow. Generally speaking, it is important to know whether or not the property you are considering purchasing can generate enough positive cash flow to cover its operating expenses and turn a profit. EGI may not be the only metric used for this purpose, but it is definitely unique in its inclusion of potential losses caused by vacancies or partial payments. For this reason — despite the fact that it is more or less an estimation — many investors find it to be incredibly useful when comparing between potential investments.