What is Effective Gross Income (EGI)?
Effective Gross Income (EGI) is the potential gross income generated by a rental property plus other incomes and less forecasted or existing vacancies and credit costs.
Rental revenue earned from a rental property is not the only variable that should be considered when assessing the value of a rented property; profits obtained from other services on the premises should also be considered and recognized on financial statements. Moreover, rental units may trigger a loss via vacancies, legal costs, or renovations.
Effective Gross Income (EGI) is the potential gross income that can be generated by a rental property plus other incomes and less forecasted or existing vacancies and credit costs.
EGI is critical when determining a property’s value as it provides insight on how much revenue the property will potentially generate after rentals, vacancies, and payment issues that may arise are factored in.
Effective Gross Income can be calculated as Potential Gross Rental Income + Other Income – Allowances for Vacancy and Bad Debts
Understanding Effective Gross Income (EGI)
EGI is a key variable in determining the value of a rental property and the true positive cash flow that property could generate. Rental cash flow is not a simple calculation but includes all forms of income generated by the property minus the realistic costs involved with rental income. If we look at the variables of the EGI formula, we can see how rental income plays out in the real world.
Effective gross income is calculated by adding the potential gross rental income with other income and subtracting vacancy and credit costs of a rental property.
EGI is key in determining the value of a rental property and the true positive cash flow it can produce.
Gross potential rental income is the hypothetical amount an investor would receive not considering the negative situations associated with rental properties.
Some of the most common examples of other income generated from rental properties include storage units, pet fees, monthly parking permits, and on-premise vending machines.
Formula for Effective Gross Income
Effective Gross Income can be calculated as follows:
EGI = Potential Gross Rental Income + Other Income – Allowances for Vacancies and Bad Debts
How to Compute Effective Gross Income
To calculate effective gross income, it is important to obtain all the relevant information pertaining to all the revenue generation avenues of a rental property. The first step in computing the EGI is to calculate the potential gross income. The potential rental income is the potential gross income.
The next step would be to sum up the other incomes that are received from the property. The incomes can come from parking fees, vending machines, etc. They are added to the potential gross income.
After summing up all the income generated or to be generated by the property, the next step is to account for allowances of bad debts and vacancies. They are deducted from the total income generated. A vacancy allowance is used to refer to income lost due to an unoccupied unit. A bad debt allowance is an allowance for tenants who may fail to may payments, despite occupying the unit.
After deducting all the allowances, the computation for the EGI is complete.
Why Is Effective Gross Income (EGI) Important?
Effective gross income is a key variable to consider when evaluating the value of an investment property for sale. As mentioned, this metric gives real estate investors a clear picture of the actual amount of income the property will generate after factoring in potential vacancy and rent issues. Two comparable rental properties charging the same amount of rent could have significantly different EGI if their estimated vacancy rates or collection rates differ
As a real estate investor, you need to know whether the rental property you are looking to purchase would generate enough rental income to cover your operating expenses. You’ll need effective gross income to determine key property income metrics such as the Net Operating Income (a metric used when no loan is taken to finance the purchase of property) and pre-tax cash flow (used when a loan is taken).
NOI helps investors to calculate the cap rate of the property, which in turn helps them determine the value of the property and compare it with other similar investment properties. On the other hand, pre-tax cash flow is used to calculate cash on cash return.
Effective Gross Income Example:
Let’s step into an EGI calculation. Say you own a 100,000-square-foot industrial property. The asking rental rate is $5 per square foot per year. This gives you a $500,000 rental GPI. You then add other income: In this case, we’ll say there are vending machines on-site which generate a combined revenue of $2,000 per year. Finally, based on your knowledge of the industrial market in your area, you know that you can reasonably project vacancy and credit costs of $50,000 per year.
EGI = $500,000 + $2,000 – $50,000
EGI = $452,000
For more information about how each figure was calculated, refer to the explanations below.
Gross potential rental income
To calculate the gross potential rental income, take your asking rates and multiply them by the relevant square footage or unit count. For example, if you have a 20,000-square-foot office property with asking rents of $15 per square foot, you would simply multiply 20,000 square feet by $15, resulting in a gross potential rental income of $300,000.
This can get more complicated, of course. Let’s say that you charge a higher rate for 5,000 square feet of recently renovated space on that building’s second floor. In this case, you would calculate your gross potential rental income by multiplying 15,000 square feet with your standard asking rate of $15 per square foot, then adding in your premium 5,000 square feet with a rate of $20 per square foot — resulting in a GPI of $325,000.
This category of income includes all non-rental income for your property. Common items to include here are parking revenues, storage unit fees, vending machine income, etc. For multifamily properties, this could also include income from laundry machines, pet fees, etc.
Vacancy and credit costs
Here’s where things may get a little tricky. As part of your EGI calculations, it’s essential to forecast costs associated with vacancies or credit costs. This basically follows the assumption that a property will rarely sustain full occupancy for a one-year period and, similarly, that rent payments may not always be paid — even if a unit or space is occupied under contract.
If you are an experienced commercial real estate investor, it can be useful to draw upon similar assets to estimate these costs. If not, utilizing current market reports or industry data can be invaluable in your projections.