An investment property is a lucrative investment, but only if it’s profitable. One of the biggest mistakes early real-estate investors make is taking a property at face value and not accurately understanding how much money is coming in and, crucially, all the ways in which it’s going out.
Calculating a property’s income and profitability is a key factor in any purchase or investment decision, and it’s something banks and financial institutions will look at before lending money for a real estate purchase. Effective Gross Income, or “EGI” for short, is an important metric used to understand whether a property generates enough positive cash flow to cover monthly operating expenses and to assess a property’s valuation.
In this article, we’ll talk about EGI—what it means, when to use it, and the components that make up the EGI formula.
What is Effective Gross Income (EGI)?
Effective Gross Income is the income generated by a property. This includes rent, tenant reimbursements, and income from other sources, such as laundry machines, late fees, etc. The EGI is defined as a property’s potential gross income after deducting vacancy and credit costs.
This figure is critical to understanding a property’s valuation and cash flow. It gives potential investors a better understanding of a property’s income-generation potential, leading to more informed purchase decisions since rental revenue earned from a property is not the only variable that goes into determining its rental value. Other services on the premises must be considered, as well as losses triggered via vacancies and bad debt.
To illustrate, let’s say you’re planning to purchase a multifamily apartment building with five units, each of which will bring in $1,000 per month in rental income. Therefore, your annual rental income from this property is $12,000 for each apartment and $60,000 in total. This is your potential gross income.
However, while the potential gross income gives you a fair idea of what you can command as rent, it doesn’t consider any additional income or losses, both of which are key to determining the true profitability of the property. Let’s say the vacancy rate of the property is 10%. Therefore, assuming that your properties will be empty 10% of the time, the income is $54,000. Add in other expenses, such as credit costs, and now we’re arriving at a more realistic number. This is the Effective Gross Income.
Why is Effective Gross Income Important?
Effective Gross Income is not only a measure of a property’s value and its income-generating potential, but it’s also used in other important metrics, such as the Net Operating Income (NOI) and Capitalization Rate or cap rate.
The NOI and cap rate are typically calculated to arrive at an offer on a property, and the EGI forms an important part of those calculations. A real estate investor will arrive at the bid price by dividing the NOI by the cap rate, and the EGI forms the revenue portion of the NOI number.
Therefore, when you’re thinking of buying a property, you’ll want to calculate the EGI to estimate the real-world income of the property, but you’ll also want to use it in other calculations to get more accurate valuation numbers.
Plus, if you’re using this rental income to generate a cash flow that will support your lifestyle or fund another purchase, it’s important not to overestimate the income. Effective Gross Income helps you do that.
Calculating Effective Gross Income
The Effective Gross Income formula is as follows:
Effective Gross Income = (Potential Gross Rental Income + Other Income) – (Vacancies + Credit Loss)
What will be key to arriving at an accurate number for the EGI calculation is accounting for all the potential revenue generation opportunities for the rental property. You’ll also want to do sufficient research to know that you’ve arrived at a realistic number for what you can charge as rent. Both overestimating rental rates and underestimating the other income opportunities, such as gym fees, parking fees, laundry, etc., can lead to an inaccurate EGI calculation.
The components of the EGI formula
Let’s break down the EGI formula’s components and discuss each in detail.
Gross Potential Income
Gross Potential Income, or GPI, is the maximum potential rental income you can generate from a property as a landlord. The GPI is calculated by multiplying the monthly rent by 12. The gross potential rent calculation assumes a couple of things:
- There is 0% vacancy, that is, all units are occupied all of the time.
- All rents are paid in full each year, and there are no missed payments or bad debts.
Other sources of income
In addition to the Gross Potential Income, the Effective Gross Income also considers the non-rental income the property generates. It’s important to be thorough in listing all this income because it directly impacts the Effective Gross Income and, therefore, other important calculations, such as the NOI and cap rate as well. Some common income sources include:
- On-premise coin-operated laundry machines
- Parking fees or permits
- Gym feels
- Pet fees
- Storage unit fees
- Furniture rentals
- Vending machine income from on-premise vending machine
- Clubhouse rentals or fees for the use of common areas for events
- Common area maintenance
- Late fees or penalties
- Lease termination fees
Vacancy
While all landlords would prefer to have properties with a 100% occupancy rate, vacancies are common and must be accounted for. With long-term tenants in single-family properties, it’s common to have properties rented out for the full year. However, when those tenants move, there will be inevitable vacancies while you fix up the place or run repairs, prepare the property for new tenants, and run background checks on potential renters.
The average vacancy rate for a rental property in the US is 6.8%, though you could be more conservative with your estimate and push that percentage higher for your calculations.
When a property is vacant, it doesn’t bring in rental income, so it’s important to account for those losses in our EGI calculation to arrive at an accurate number.
Credit losses
Credit losses or credit costs happen when a unit has been rented out, but the renter hasn’t paid the rent in part or entirety. This is a loss for the landlord and can, of course, also lead to a higher vacancy rate. As with the vacancy costs, the credit loss is an important factor to account for in the EGI calculations, especially since it can take 60-90 days to legally evict someone from a property. During that 90-day (or more) period, the landlord is not earning the rent on the property. This is also sometimes referred to as an economic vacancy.
Credit losses can be challenging to estimate because they vary based on location, property, tenant selection process, and several other factors. You’ll want to look at historical data to arrive at a representative assessment.
Other factors that affect EGI
There are a couple of other terms to understand that will impact the Effective Gross Income and, therefore, the profitability of your rental property. These are:
Downtime: This is the cost of having unoccupied rental units. The difference between downtime and vacancy is that downtime refers to the period between the expiration of one lease and the beginning of another. Vacancy is typically when a unit is empty because it hasn’t been rented.
Turnover: Turnover is often used in commercial real estate to refer to the costs of preparing a property or unit for the next tenant. It includes minor repairs and maintenance costs but not significant upgrades. Turnover can be counted towards EGI, though more often, it forms a part of a property’s operational expenses.
The bottom line
Effective Gross Income, or EGI, is a good metric for getting a basic understanding of what a property’s cash flow and valuation might be. This can be incredibly helpful when making an investment decision or when comparing two properties against one another.
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