What it means
When valuing an investment property, the maximum possible rent is not a realistic number, because no building is full and every tenant pays on time all the time. Effective gross income starts with potential gross income, the rent the property would earn if every unit were occupied at market rent.
It then deducts a realistic allowance for vacancy and credit loss, and adds other income that the property generates. Other income can include parking fees, laundry machines, storage rentals, late fees or vending income.
These items are often small but can add up, especially in large buildings. Including them gives a more complete picture of what the property actually brings in.
The figure is used by investors, lenders and valuers to estimate what a property is worth. After deducting operating expenses from effective gross income, they reach net operating income, and dividing that figure by a capitalisation rate gives an estimated value.
A small error in effective gross income therefore flows directly into value. The vacancy allowance is a judgement, not a fact.
Analysts base it on the building's history and on typical rates for similar properties in the area, and cautious investors often use a higher allowance than the current vacancy level. A building that is fully let today may still need an allowance because tenants move out over time.
Lenders often test the numbers by adjusting vacancy upwards and by checking whether the property could still pay its mortgage. It is therefore wise for owners to document how the vacancy allowance was chosen.
Clear and conservative assumptions help build trust with lenders and buyers. Finally, effective gross income is not profit.
It is revenue before operating costs, financing costs and tax, and it is only the first step in assessing a property's return.
In practice
Real-world examples.
Example
An investor looks at a 20-unit apartment block that could earn $500,000 if fully let. After allowing 6% for vacancy and adding $20,000 of laundry and parking income, the effective gross income is $490,000.
Example
A shopping centre owner reviews the budget for next year. Two tenants are expected to leave and one is behind on rent, so the owner raises the vacancy and credit loss allowance from 4% to 8%.
Example
A bank assessing a mortgage application for an office building asks for the rent roll, which lists every tenant and rent. The bank calculates its own effective gross income using a more cautious vacancy rate than the owner's. The bank then tests whether the property can still cover its loan payments under that tougher view.
Formula
Calculation
EGI = Potential gross income - Vacancy and credit loss + Other income
Worked example for a small apartment building:
Potential gross income: $500,000
Vacancy and credit loss allowance: 6% of $500,000 = $30,000
Other income (parking and laundry): $20,000
EGI = $500,000 - $30,000 + $20,000 = $490,000
If operating expenses were $190,000, net operating income would be $490,000 - $190,000 = $300,000. At a capitalisation rate of 6%, the estimated value would be $300,000 / 0.06 = $5,000,000.Case study
Seen in the real world.
This is a fictional story. Elmwood Residential, an invented property company, was considering buying a 40-unit apartment complex. The seller's brochure showed potential rent of $500,000 and implied the building was always full.
The buyer's analyst built her own effective gross income. She used a 6% vacancy and credit loss allowance based on the local market, which removed $30,000, and added $20,000 of parking and laundry income that she could verify in the bills.
Her effective gross income was $490,000, and after expenses of $190,000 she estimated net operating income at $300,000. That was lower than the seller's figure, so the buyer negotiated the price down by about $250,000. The company and figures are illustrative. The analyst noted that each 1% change in vacancy moves effective gross income by $5,000, so the assumption deserved careful thought. Her report set out the reasoning so that the investment committee could challenge it.
Watch out
Common mistakes.
- Using potential gross income as if it were what the property really earns. Vacancies and unpaid rent reduce actual income.
- Adding other income without evidence. Only include items that can be supported by past bills or contracts. Auditors and lenders will ask for the evidence.
- Using the current vacancy rate when it is unusually low. A cautious allowance reflects tenants moving out over time.
Questions
People also ask.
What is the difference between potential gross income and effective gross income?
Potential gross income assumes full occupancy at market rent, while effective gross income deducts realistic vacancy and credit loss and adds other income.
How is EGI used in property valuation?
Deduct operating expenses to get net operating income, then divide by a capitalisation rate to estimate value.
What is a typical vacancy allowance?
It varies with the market and property type, and valuers base it on local history and comparable properties.
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