Effective Gross Income
An industrial property's effective gross income is not just its rent — you must also add in all other revenue, from vending machines to parking fees.
Effective Gross Income
Effective gross income, or EGI, is a forecast of an asset’s income. It isn’t strictly limited to rental payments — any revenue generated from a property should be considered.
You’ll need to have three figures on hand to calculate your property’s EGI:
Rental gross potential income (GPI)
Other income
Vacancy and credit costs
What is effective gross income in commercial real estate?
Effective gross income, or 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 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.
How is effective gross income calculated in commercial real estate?
Effective gross income in commercial real estate is calculated by taking the Gross Potential Rent (GPR) plus any other income generated by the property, and subtracting the property's vacancy, credit loss, and loss to lease.
Gross Potential Rent (GPR) is the maximum amount of rental income a property could generate at market rent, given it has 100% occupancy. Other income typically includes vending machines, laundry machines, parking spot rental, storage, pet fees, and late fees for multifamily properties. Vacancy rates can vary depending on the type of property, with the average vacancy rate for traditional commercial or multifamily properties being 7%. 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. Loss to lease refers to the lost opportunity for income calculated between market rates and the effective in-place rents a property is charging.
The formula for effective gross income (EGI) is:
Gross Potential Rent + Other Income - Vacancies - Credit Loss - Loss to Lease = Effective Gross Income
What factors affect effective gross income in commercial real estate?
Effective gross income in commercial real estate can be affected by several factors, including downtime, turnover, vacancy, credit loss, and loss to lease.
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 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.
Vacancy is the amount of time that a unit is unoccupied, and is usually expressed as a percentage of the total number of units.
Credit loss is the amount of money that a landlord loses due to tenants not paying rent, and is usually expressed as a percentage of the total rent.
Finally, loss to lease is the amount of money that a landlord loses due to offering incentives to tenants, such as free rent or discounted rent.
What is the difference between effective gross income and gross income in commercial real estate?
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. In contrast, gross income is the total income generated by a property before any expenses are subtracted.
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How does effective gross income affect small business financing?
Effective gross income (EGI) is an important factor in small business financing because it is used to forecast an asset's positive cash flow. 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 instance, if a small business is looking to purchase a commercial property, they can use EGI to determine whether the property can generate enough income to cover its operating expenses and turn a profit. This can be done by calculating the EGI in one of two ways: a simple EGI calculation or a complex EGI calculation. A simple EGI calculation would involve taking rental income, adding other income, and subtracting the property’s vacancy. 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.
By using EGI to forecast an asset's positive cash flow, small business owners can make more informed decisions when it comes to financing a commercial property. This can help them to determine whether the property is a good investment and whether they can afford the loan payments.
What are the benefits of understanding effective gross income for small business financing?
Understanding effective gross income (EGI) is important for small business financing because it helps investors determine whether a property can generate enough positive cash flow to cover its operating expenses and turn a profit. EGI takes into account potential losses caused by vacancies or partial payments, which can be useful when comparing between potential investments. Additionally, EGI can be calculated in one of two ways: a simple calculation that only involves taking rental income, adding other income, and subtracting the property’s vacancy; or a complex calculation that factors in potential market rental income, loss to lease, vacancy, and credit loss, while adding any other income generated by the property.
For more information, please see What Is Effective Gross Income? and Effective Gross Income in Commercial Real Estate.
The Formula
Once you have the values of those metrics listed above, the calculation itself is straightforward:
EGI = Rental GPI + Other income - Vacancy and credit costs
A Simple Example
Let’s step into an EGI calculation. You own a 200,000-square-foot industrial property. The asking rental rate is $2.50 per square foot per year. This gives you a rental GPI of $500,000. You would then add your other income. For this distribution center, let’s say you have some on-site vending machines which generate $2,000 each year. Lastly, based on your knowledge of the local industrial market, you are able to reasonably assume vacancy and credit costs will be $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 50,000-square-foot manufacturing facility with asking rents of $7 per square foot, you would simply multiply 50,000 square feet by $7, resulting in a gross potential rental income of $350,000.
This can get more complicated, of course. Let’s say that you charge a higher rate for 20,000 square feet of recently upgraded space on one side of the structure. In this case, you would calculate your gross potential rental income by multiplying 30,000 square feet with your standard asking rate of $7 per square foot, then adding in your premium 20,000 square feet with a rate of $10 per square foot — resulting in a GPI of $410,000.
Other Income
This includes all non-rental income for your property. Common items to include here are parking revenues, vending machine income, and other miscellaneous income.
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 follows the idea that a property will rarely sustain 100% occupancy for a full one-year period, and even if all your space is occupied under a lease, rent payments may not always come in.
If you are an experienced commercial real estate investor, it can be useful to draw upon comparable assets to estimate these costs. If not, utilizing current market reports or industry data can be invaluable in your calculations.