July 6, 2023
Adam Hoeksema
Today, we're diving deep into an integral aspect of the real estate industry: Effective Gross Income (EGI). Understanding the concept of EGI is crucial for real estate investors, property managers, and analysts alike. It's the heartbeat of your real estate investment's financial health, giving you an accurate picture of your property's potential income after considering losses like vacancy and credit risks. To simplify this further, we're also demonstrating how our various real estate pro forma templates include an EGI calculator to simplify the math behind the key numbers.
As I have been diving deeper into the world of real estate financial modeling, I keep realizing how important the effective gross income is for a property, so I wanted to dedicate a blog post to cover the topic in depth. I plan to hit on the following:
With that as our guide, let’s dive in!
What is Effective Gross Income?
Effective Gross Income (EGI) in real estate is a measure of the potential income from a property after accounting for vacancy and credit losses, but before subtracting operating expenses.
Here's a more detailed breakdown: When you own a rental property, the total amount of income you could possibly earn from it is known as the Potential Gross Income (PGI). This would include all the rent payments from tenants, income from vending machines or laundry facilities, parking fees, and any other income-generating aspects of the property.
However, the actual income you end up with won't be the total Potential Gross Income because there are often vacancies (periods when the property or portions of it are unrented) and credit losses (income lost when tenants fail to pay their rent). When you subtract these losses from the PGI, you get the Effective Gross Income.
EGI is a critical factor in real estate investing because it gives a more realistic estimate of the income that a property can generate. This information is vital when calculating the Net Operating Income (NOI), determining the value of a property, or comparing different investment properties.
What is EGI in Real Estate?
EGI is an acronym for effective gross income. So EGI is simply the estimate of a property's gross income after taking into account any vacancy and credit losses.
Effective Gross Income Formula
The formula for calculating Effective Gross Income (EGI) in real estate is:
Effective Gross Income (EGI) = Potential Gross Income (PGI) - Vacancy and Credit Losses + Other Income
Here's a breakdown:
Potential Gross Income (PGI): This is the total income a property would generate if it were fully rented out and all tenants paid their rent in full.
Vacancy and Credit Losses: This is the estimated amount of rental income lost due to vacant units and tenants not paying their rent.
Other Income: This is any income generated from the property that is not derived from rent. Examples might include income from laundry facilities, vending machines, parking fees, etc.
By subtracting the Vacancy and Credit Losses from the Potential Gross Income and adding any Other Income, you arrive at the Effective Gross Income. This gives a more accurate depiction of the property's potential income compared to just looking at the Potential Gross Income alone.
Why is Effective Gross Income so Important?
Effective Gross Income (EGI) is a crucial metric in real estate for several reasons:
- Realistic Financial Picture: EGI provides a realistic view of a property's income potential. Unlike Potential Gross Income, which assumes full occupancy and total rent collection, EGI factors in real-world issues such as vacancies and uncollected rent. This realistic assessment helps investors and property owners make informed decisions.
- Basis for Other Calculations: EGI is used to calculate Net Operating Income (NOI), one of the most critical figures in real estate. NOI, which is EGI minus operating expenses, provides an estimate of the property's profitability before taxes and financing costs. This helps determine the cash flow from a property, informing decisions about property value, sales price, and whether an investment is likely to be profitable.
- Investment Analysis: EGI is often used to compare different investment properties. It helps investors understand which property has a better income potential, and thus, which might yield a better return.
- Loan Considerations: Lenders often look at EGI when determining whether to approve a loan for the purchase of a property or when refinancing. A higher EGI indicates a higher income potential, which improves the borrower's chances of loan approval.
Therefore, understanding and correctly calculating EGI is vital in real estate investment and management. It forms a key part of the financial analysis of a property, helping stakeholders make informed decisions and plan for the future.
Effective Gross Income vs. Gross Potential Income
Effective Gross Income (EGI) and Gross Potential Income (GPI), also known as Potential Gross Income (PGI), are two important financial concepts in real estate, but they represent different stages of income calculation for a rental property.
Gross Potential Income (GPI):
This is the maximum amount of income a property could generate if it were fully occupied and all tenants paid their rent on time in full. GPI doesn't account for any losses due to vacancy or non-payment of rent by tenants. It's essentially the best-case scenario, assuming perfect conditions.
Effective Gross Income (EGI):
This takes the GPI and adjusts it for real-world conditions. EGI is calculated by subtracting any income lost due to vacancies (empty units or periods when the property is not rented out) and credit losses (lost income due to tenants not paying their rent) from the GPI. Sometimes, EGI may also include other income, such as revenue from laundry machines, parking fees, or other services.
The primary difference between the two lies in their realism. While GPI represents an ideal scenario, EGI gives a more accurate picture of the actual income a property is likely to generate, taking into account common issues such as vacancies and non-payment of rent.
Effective Gross Income vs. Net Operating Income
Effective Gross Income (EGI) and Net Operating Income (NOI) are two crucial financial metrics in real estate, but they serve different purposes and provide different insights into a property's financial performance.
Effective Gross Income (EGI):
This is the potential income from a property after accounting for vacancy and credit losses, but before subtracting operating expenses. EGI is calculated by taking the Gross Potential Income (maximum income a property could generate if fully occupied and all rents were collected) and subtracting any income lost due to vacancies and credit losses. Additional income sources like laundry or parking fees are also included.
Net Operating Income (NOI):
This is the total income a property generates after accounting for all operating expenses but before accounting for mortgage payments, depreciation, and taxes. To calculate NOI, you take the EGI and subtract all operating expenses. These expenses include costs like property management fees, repairs and maintenance, utilities, property insurance, property taxes, and any other costs associated with operating and maintaining the property.
The main difference between EGI and NOI is that EGI gives you a picture of a property's income after accounting for vacancies and credit losses, but before operating expenses. In contrast, NOI provides a snapshot of the property's profitability after all operating expenses have been paid, but before debt service (mortgage payments), capital expenditures, depreciation, and taxes.
Effective Gross Income Calculator
Again, the formula for calculating Effective Gross Income (EGI) in real estate is:
Effective Gross Income (EGI) = Potential Gross Income (PGI) - Vacancy and Credit Losses + Other Income
In order to actually calculate this for a real estate property, you are probably going to want a spreadsheet that allows you to enter in assumptions for the number of units available to rent, the monthly rent, the expected vacancy rate and credit losses, etc.
All of our real estate developer and real estate acquisition templates have a section built in that allows you to calculate the effective gross income. Below you can see an example from our Multifamily Developer Pro Forma Spreadsheet.
Example of multifamily revenue assumptions
Example of multifamily vacancy and credit loss assumptions
Example of multifamily other income assumptions
Example of Effective Gross Income Calculation
After entering in all of these assumptions, our templates will calculate the projected effective gross income as seen below:
How to Value Real Estate Properties
Here are some common methods used to value real estate properties:
- Comparative Market Analysis (CMA): This is the most commonly used method, especially in residential real estate. It involves comparing the property to similar properties (comps) that have been sold recently in the same area. Factors like the number of bedrooms, bathrooms, the property's condition, location, size, and unique features are considered in the comparison.
- Cost Approach: This method is used when a property is so unique that there aren't valid comparables, or for new construction. It estimates how much it would cost to replace the existing property, considering the cost of land and the cost of construction, less depreciation.
- Income Capitalization Approach: This method is commonly used for income-generating properties. It values a property based on the net income it produces. The Net Operating Income (NOI) is divided by the capitalization rate (a rate of return required by an investor) to get the property value. The formula is: Property Value = NOI / Capitalization Rate.
- Gross Rent Multiplier (GRM): This method is a simple way to value rental properties. It involves dividing the property's price by its gross annual rental income. Lower GRM values may signify a better investment opportunity, but it's a rough estimate as it doesn't account for operating expenses.
- Discounted Cash Flow (DCF) Analysis: This is a more complex valuation method used for larger commercial properties. It involves projecting the future cash flows that the property will generate and then discounting them back to the present value using a discount rate.
Remember, no single method is perfect for every scenario. Often, a combination of methods will provide the most accurate valuation.
Effective Gross Income Multiplier
Although it may be a less common method in valuing real estate, you could also use an effective gross income multiplier approach.
The Effective Gross Income (EGI) Multiplier approach is a method for valuing income-producing properties. It's similar to the Gross Rent Multiplier (GRM) method but takes into consideration a more complete view of the property's income potential.
The EGI Multiplier is calculated by dividing the property's sale price by its Effective Gross Income:
EGI Multiplier = Sale Price / Effective Gross Income
This method provides a quick and simple way to estimate the value of a property and compare different investment opportunities. A lower EGI multiplier suggests that a property might offer a better return on investment, given that it suggests a lower price for each dollar of income the property generates.
However, like the GRM, the EGI multiplier is a rough estimate and should not be the sole method used for property valuation. It doesn't take into account the property's expenses, and therefore, it doesn't provide information about the property's profitability or Net Operating Income (NOI). For a more complete valuation, other methods like the Income Capitalization Approach, which takes expenses into consideration, should also be used.
I hope this has been helpful! If you run into any questions as you look to calculate your effective gross income please reach out!
