Effective Gross Income Explained: What It Is and Why It’s Important
Effective gross income (EGI) is the income from all property operations after adjustments for vacancy (physical and/or economic). Income from operations consists of rental income from tenants and income from other sources like RUBS/tenant reimbursements for expenses, parking, laundry, etc.
In simpler terms, effective gross income is the total collected income that the owner can reasonably and defensibly project. All of the activities that result in the EGI are usually found in the top section of a real estate cash flow model, under the title “Income”. As with most figures that appear in a real estate analysis, it can be derived from past operations or future projections.
EGI is one of the most important figures in a cash flow model, providing a bottom-line income figure used with operating expenses to determine net operating income and cash flow.
Getting to a figure for EGI may seem straightforward but investors, brokers and lenders across the country and across property types use more than a handful of different methods. Each method varies in both the level of detail and the order of information presented. Some of the line items, for example showing “market rent”, expose additional information that can enhance one’s understanding of the property and help make better decisions.
Understanding Effective Gross Income: How RE Participants Differ
This article serves to dive into the various elements of effective gross income. But before we unpack it, it’s important to keep in mind two ways in which real estate participants often differ in their practices.
- Adjustments: Many professionals make adjustments to their cash flows based on their goals and those of the stakeholders with which they do business. This article provides general guidelines, but will almost certainly differ from many other versions and may omit reference line items mentioned elsewhere. If it’s in here, we think it’s important.
- Overlapping terms: Real estate participants sometimes use two different terms that mean the same thing, or use the same term when each is referring to a different thing. The use of one or the other may vary based on property type and/or what line items are or are not applicable to property operations. Discrepancies or misunderstandings are especially common with the terms that make up EGI. The list below provides some examples. Once you understand what each means, it becomes easier to understand someone else’s figures and, if necessary, convert them to your desired format.
Potential Market Rental Income = Market Rent, Potential Rental Revenue
Potential Rental Income (PRI) = Gross Potential Rent, Potential Base Rent
Effective Rental Income (ERI) = Net Rental Income (NRI), Scheduled Base Rental Income, Rental Income
Potential Gross Income (PGI) = Potential Gross Revenue (PGR)
Effective Gross Income (EGI) = Effective Gross Revenue (EGR) Gross Operating Income
Two Examples of Different Methods Used to Calculate EGI
Below is an example of two possible versions of a cash flow model, that might be used by two different participants, for the same property, showing different methods of getting to an effective gross income figure.
The detailed version provides two distinct advantages: it accounts for credit loss and has a glaring zero for expense reimbursements which are common and an opportunity for many to boost EGI. The zero screams “opportunity for additional revenue.” Credit loss (more on this below), is sometimes overlooked—especially when someone accounts only for physical vacancy only to the exclusion of economic vacancy.
While projections in the simple version could end up being more accurate than the detailed version when compared to actual outcomes, it’s clear that the “detailed” version accounts for additional items that often impact effective gross income. The additional items in the detailed view can increase accuracy by incentivizing the modeler to find data at the property and market level to support the figures. Having greater detail also provides a basis from which changes can be monitored and possibly acted upon.
Let’s dive into the various figures and variables behind effective gross income.
Market Rental Income, Potential Gross Income, and Loss to Lease/Gain to Lease
The first thing you may notice in the detailed view is potential market rental income and “(loss to lease/gain to lease).” For those who first learn about these terms, it can seem odd that they are included in the cash flow model even though they reference information that isn’t affecting actual cash flow. We’ll explain why they’re useful below.
- Potential market rental income is the total rental income the property could achieve if all spaces were occupied and leases were at market rates. Some pros assume market rent potential based on the property’s current condition, others assume the property is renovated when determining market rents. It’s important to understand how someone arrived at the figures in this line, as it is often subject to optimistic (or overly optimistic) assumptions. There could be an underlying assumption that an extensive renovation is the reason for the stated rents, yet the renovation costs are omitted from the cash flow.
- Potential rental income (PRI) is the total potential income attributable to tenant rent at full occupancy, which is determined by adding the current rental income from occupied units and assumptions of lease rates for any vacant units based on their current condition. In some cases, you might see and/or want to add a line for rent concessions and/or non-revenue units, both deductions from potential rental income that are factored into the calculation for effective rental income.
- Potential gross income (PGI) is PRI plus potential other income. In cases where a vacancy factor is applied to PRI and potential other income, PGI can be used to show potential income from all sources.
- Loss to lease/gain to lease is the difference between potential market rental income and potential gross income. This line can provide important insights around the opportunity cost, or favorability, of current lease rates vs. potential lease rates.
Here’s an example using a single family house rental:
If a monthly cash flow analysis shows a loss to lease of $200, it means that the potential market rent is $200/month above the current rental rate. In other words, the landlord is earning $200 less with the current lease structure than they could earn by adjusting the lease term to the market rate.
Loss to Lease is a powerful tool, not only for showing a property’s income producing potential but to support decisions around the ROI on renovations, lease renewals, setting lease rates, tenant buyouts, and much more.
Physical vs. Economic Vacancy and Credit Loss
- Vacancy can be physical (no tenant present) or economic (present tenant not paying rent). When projecting vacancy, a single figure is used that applies to the possibility of either. When looking at a single period of operating data, or past operating data, it can be helpful to determine the breakdown of total vacancy into physical vs. economic, as this can inform decisions around adjustments to asking lease rates, evictions, “cash for keys” arrangements, etc. Vacancy can be calculated using actual lease end/start dates, projected lease end/start dates, and/or applying a percentage of a total income line item, based on market data, e.g. applying a 5% vacancy factor to potential rental income.
- Credit loss, sometimes referred to as “bad debt,” accounts for the loss or potential loss of income due to lease default, which is often based financial strength and/or credit quality.
Both vacancy and credit loss are often determined by using percentages that are applied to potential rental income or potential gross income (which includes rental income and income from other sources), which result in an amount that is deducted from PRI or PGI, which in turn reduces EGI, which in turn reduces NOI and cash flow.
Within cash flow models, the vacancy factor should only affect the model if actual vacancy is between 0% and the vacancy factor. For example, if actual vacancy is 50%, and the cash flow model has an assumption of 10%, the Vacancy line item will show a $0 impact. As soon as actual vacancy is less than 10%, the Vacancy line item should reflect an off-set to PRI.
Other Income refers to any revenue that is not part of the rent paid by tenants as part of their lease agreement with the landlord that legally permits them to occupy the space. Examples include income from leasing parking spaces, charging pet rent, a lease with a laundry company, etc.
One consideration that is often overlooked is whether certain other income items should be impacted by the vacancy factor. As a general rule, if an item is correlated with tenant occupancy it makes sense to include it above the vacancy line, so that the vacancy line item appropriately accounts for the reduction of income. An example of this is ratio utility billing system (“RUBS”), where the income derived will be directly impacted by the percentage of occupied units.
Other income items that shouldn’t be impacted by vacancy are those that are not correlated with occupancy, for example a lease from a laundry company with a fixed monthly rental rate.
Downtime and Turnover Costs
Downtime and turnover costs are two sides of the same coin, as they both lead to reductions in NOI that are the result of unoccupied space between tenancy. Both items are usually determined by market leasing assumptions. While turnover is usually included as an operating expense, thus not part of the calculation needed to reach EGI, it is directly associated with tenancy. It is often treated incorrectly, which is why it’s mentioned here for clarity.
- Downtime, like vacancy, is a charge against PRI. It reflects opportunity costs of having unoccupied space, which starts when a tenant vacates and continues until the space is leased. The use of downtime is more common in instances where a property is undergoing significant renovations and the long periods of vacancy due to renovations will not be the norm for the duration of the analysis.
- Turnover costs are the costs associated with putting a recently occupied space in rent-ready condition for a future tenant, not including any kind of tenant-specific allowance (TIs) like minor repairs and cleaning. While this amount differs from space to space and tenant to tenant, a general estimate is usually made. In most cases, turnover costs should only include those that can be expected at the end of a typical tenancy and should not include infrequent renovations or the replacement of major capital items.
However you decide to determine EGI in your models, it’s important to get skilled at reconciling differences between your numbers and those to which you are exposed. Since your preferences, and possibly your terminology, likely differ from others in your sphere of influence, it’s wise to apply a checklist of what you need to reach your version of EGI and make any required adjustments. This applies whether you are looking at someone else’s numbers that include EGI or NOI, cap rate, and any other metric from which EGI stems.