Buying an investment property can be a lucrative investment option. However, many beginner real estate investors fail because they don’t know how to estimate the true income potential of an investment property. Determining how much to expect from a rental property isn’t as simple as multiplying the rental rate by 12. To have a realistic forecast of how much you’ll actually make, you need to learn how to calculate effective gross income (EGI).
Effective gross income is a crucial factor to consider when buying investment property. In this article, we’ll cover what effective gross income means and how to calculate it.
What Is Effective Gross Income?
Effective gross income (EGI) is the true amount of income that a rental property is expected to generate. It is the total income expected from all operations of the rental property after an allowance is made for the revenue that is lost as a result of vacancy or unpaid rents. After all, nothing is perfect all the time and you need to account for this.
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.
The Effective Gross Income Formula Explained
EGI can be calculated by taking the potential gross income from a rental property, adding other forms of income accrued from the rental, and deducting vacancy costs and credit costs.
Here’s the effective gross income formula:
Watch our video below to learn how to calculate effective gross income in real estate investing:
Let’s now break down the elements of the effective gross income formula so that you understand what they mean.
1. Potential Gross Income
Potential gross income is the maximum amount of rental income that the rental property would generate at market rent if it had 100% occupancy during the year. This is a hypothetical amount since it assumes that the income property will be rented for the entire year and that tenants will pay the full rental amount as agreed upon and documented in the lease.
For example, if you are considering buying an apartment building with 10 units and each rents for $1500 per month, your potential gross income is $1500 × 10 ×12 = $180,000.
However, in the real world, this is hardly the case. Therefore, as a real estate investor, you can’t rely on this figure. You need to factor in other costs such as vacancies and tenant debt. As seen in the EGI formula above, these costs will be taken into account when calculating the effective gross income of a rental property.
2. Other Income
When calculating effective gross income in real estate, you also have to factor in additional revenue generated from the operation of the income property that is not part of the monthly rental payments. This may include income from on-premise amenities, services or add-ons that renters pay for separately. Landlords can explore a variety of creative sources of income to boost their cash flow.
Miscellaneous income from a rental property may include but is not limited to:
- Laundry machines
- Vending machines
- Parking permits
- Storage space
- Gym fees
- Late fees
- Lease termination fees
- Pet fees
- Common area maintenance
- Room revenue
This additional income contributes to a rental unit’s worth and should be included in the calculation of EGI.
3. Vacancy Costs
Not all rental units will be occupied all 12 months of the year. In real life, a rental unit may stay vacant a few times in the year before you find a new tenant. This means that, during this period, the real estate investor will not be receiving rent and will have a loss in income. Therefore, when calculating effective gross income, it’s essential to factor in the vacancy costs. This is the amount of money the owner is likely to lose based on the average vacancy rate in the area of comparable properties and historical data from the property.
From our earlier example, if the average vacancy rate is 10%, at any given time, 1 out of the 10 units will be vacant. The vacancy cost will be $1500 × 12 = $18,000.
4. Credit Loss
Sometimes a rental unit may be occupied but the landlord does not receive expected rental income (according to the lease) because the renter is not paying any rent or the full amount. Unfortunately, to be in line with state and local eviction laws, a landlord may take 60 or more days to legally evict a tenant. During this period, the landlord will experience credit loss.
Therefore, as with vacancy costs, bad debt allowance should be taken into account when calculating effective gross income. Tenant debt can be estimated based on historical or housing market data. When you add the potential gross income and other income from the rental property and subtract the vacancy and credit costs, what you are left with is the effective gross income.
The Bottom Line
Before buying investment property, real estate investors should take into consideration its effective gross income. However, as indicated earlier, EGI isn’t enough to tell whether a rental property will make a good investment. That’s because the effective gross income does not factor in operating costs and, therefore, should not be used as the only metric for analysis.
Real estate is all about the numbers. This means that you need to analyze a good deal of key metrics to make a wise decision. Real estate investors should also use metrics that factor in the rental property’s operating costs (cash flow or NOI) as well as the return on investment (cash on cash return and cap rate). Generally, a good rental property should have a positive cash flow and generate a good return on investment.
Fortunately, with Mashvisor, you don’t have to go through the trouble of calculating all these metrics on your own. With Mashvisor’s investment property calculator, you can quickly and accurately calculate key real estate metrics including cash flow, cap rate, cash on cash return, and occupancy rate. Try it out now for yourself.