What is Effective Gross Income in Multi-Family Real Estate Investing?
Effective gross income, EGI, is the actual cash flow of a multi-family building. It’s all revenue (rent, parking, laundry machines, vending machines, etc) minus all expenses (vacancy, bad credit).
At its most fundamental, real estate investing is about earning a profit. This formula is a highly effective tool for calculating the approximate return an investor can expect from any given real estate investment.
What is Effective Gross Income?
Unfortunately, calculating how much money an investor can earn from a potential multi-family investment isn’t quite as simple as multiplying the unit number by the median rent for the area. There are a lot of factors that go into figuring out how much investors actually take home every month.
Effective gross income allows investors to do just that. It takes into consideration the ideal income from the property, if all the units were rented out, and subtracts the anticipated vacancy rate for the local area. There are also some other factors involved, as well.
Many real estate investors look at effective gross income before determining whether a new investment property will meet their needs. They want to know that a property will generate enough income to justify the investment and help them achieve their financial goals.
A property may charge premium rent, but if there are costly expenses associated with maintenance, it may not actually be a great investment.
How to Calculate Effective Gross Income
The formula for calculating effective gross income is relatively simple.
Effective Gross Income = Potential Gross Income + Other Income - Allowances for Vacancies and Bad Debts
In order to calculate it, however, investors need to know each of those variables.
Potential Gross Income
The potential gross income of a property is the income that the property has the potential to generate, assuming that all units are rented out and all rent bills are paid on time. The potential gross rental income of a property is based on the rental rates alone, not on other factors that may contribute to the owner's income from the property.
That’s where “other income” plays into the equation.
Other Income from the Property
For some types of investment property, the only income generated is from the rent itself. In other properties, however, you might have considerable additional income. Suppose, for example, that a building has a large parking lot, with more spaces than the renters can use. Renting out those parking spaces would allow investors to generate more income.
Properties might also offer amenities like:
- Vending machines
- A clubhouse that can be rented out by residents
- Coin-operated laundry
- Pet fees
Additional amenities can be a fantastic source of additional income.
These two, potential gross income and other income, make up the revenue side. Next, in order to calculate EGI, investors factor in vacancies.
The average US rental vacancy rate hovers around 6%. However, a number of factors can contribute to the anticipated vacancy rate of the property. For instance, one property type that we invest in at Valiance is student housing in heavily populated areas, where the vacancy rate is closer to 0%. While we remodeled The Prospect near UC Berkeley, for instance, 100% of the units were pre-leased.
For most rentals, though, such a low vacancy rate is uncommon.
Other factors include:
Average vacancy rates
If properties in the area don't sit empty for long due to a hot rental market and high demand, chances are, a rental property will also have comparatively few vacant units.
The type of units in your building
Some units will rent out faster than others, usually based on the demographics for the area.
For example, if it’s a complex full of seniors, they're going to prefer one and two-bedroom units. On the other hand, young families might prefer two to three-bedroom units and greenspace so that there is plenty of room for the kids. In student housing near large universities, there’s more emphasis on great community areas and less on large individual units. A similar comparable living space for students are dorm rooms, which are typically small. This allows for many renters in less space.
Whether there are specific reasons why your investment property might draw more renters or have lower rental rates
If the property is located next to a popular workplace with a number of semi-permanent or temporary employees, especially those who are more likely in general to rent than own, you may have an easier time filling your units. The same is true for virtually any higher-populated area.
To get an accurate vacancy rate for a property, investors take a look at the average vacancy rate for similar properties over the course of the year.
Next, another expense that’s factored into the EGI formula is bad debt, or credit loss.
Bad Debt or Credit Loss
If any of the tenants in a building stop paying rent, an investor obviously loses income. Credit loss could also refer to any rent lost due to promotional offers, like a month of free rent and non-revenue “model” units.
This is more popular in some areas and property types than others.
Again, the best way to calculate how much credit loss investors can expect is to research similar properties in a similar market. The numbers aren’t always easy to come by, but they’re essential for investors who do their due diligence analyzing potential investments.
An Example of Effective Gross Income Calculations
Steve is looking into buying an investment property that has 20 units, all of which have the potential to generate $1,000 in income each month. Steve discovers that the property has a typical vacancy rate of around 5%, or one unit at any given time. He also has the ability to generate approximately $5,000 in other income from the property over the course of the year through pet fees and extra parking fees.
Over the course of the year, the potential gross income on Steve's property is $245,000:
- 20 units x $1k per month x 12 = $240,000 (potential gross income
- $240,000 + $5,000 (additional income) = $245,000
- 5% (vacancy) x $240,000 = $12,000
- $240,000 - $12,000 = $228,000
- $228,000 + $5,000 of additional income = $233,000
Assuming a 5% vacancy and bad debt rate, Steve can generate an estimated $233,000 on the property per year.
How Does Knowing Effective Gross Income Benefit Investors?
Real estate investors rely on EGI to tell them how much income a property will likely actually generate. Potential gross income can offer a look at a property's ideal outcome. In the real world, it's rarely that simple. Most multifamily properties do not have every unit rented out all the time. Effective gross income calculations can tell you more about what the real income for a property will look like.
A look at effective gross income can help you choose between similar properties.
Often, comparing investment properties is a complex process. You want to be sure that you're choosing the right investment property, especially if you have more than one option to choose from. A look at effective gross income can help you determine how much income a property really has the potential to generate for you.
Effective gross income calculations can help you determine whether a specific property meets your investment needs.
When you invest in a rental property, investors need to know that it will allow them to meet their financial goals, based on the information they have available.
Evaluating effective gross income options can help you get a better idea of what improvements you might want to make to the property.
This is where Valiance Capital comes in.
While a property can start generating some equity and an income stream relatively quickly, you may need to invest more fully into your new property before it will perform at the level you're hoping for. A look at the changing effective gross income of a property, based on factors like new amenities you can offer for a fee, raising rent costs due to improvements, and other options that can help you generate additional income for your property, can help you determine what investments you want to make.
That’s exactly what we do during the research phase for our commercial real estate acquisitions. Valiance Capital reduces the costs of those improvements with our in-house construction team and lower-cost renovation options. While most construction companies build in a 15-20% profit for their work, we help our investors decrease many of those investment costs.
The result is a process that’s more streamlined, efficient, and lower cost.
Valiance Capital Can Help You Build Your Net Worth and Achieve Perpetual Prosperity
Finding the right investment property, renovating it, and setting up profitable management is a complex process. We allow you to reap the benefits of multi-family real estate investment with our done-for-you investment opportunities. Ready to get started? Contact us today for more information about our latest opportunities.
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