Effective gross income is one of the line items on a real estate pro forma that is often used by appraisers, investors, and other commercial real estate professionals. While effective gross income is conceptually easy to understand, the calculation itself can be confusing. In this article, we'll take a closer look at effective gross income and clear up any confusion.
Effective gross income formula
The formula for Effective Gross Income (EGI) is defined as a property’s potential gross income minus vacancies and credit losses.
As you can see from the Effective Gross Income formula above, Effective Gross Income is an intermediate step in calculating a property's pre-tax net operating income and terminal cash flow.
Calculating Effective Gross Revenue is simple, as shown in the formula above, but in practice there is often more nuance involved. Because commercial properties have different revenue streams, lease structures, amortizations, etc., the calculation of Effective Gross Revenue can vary depending on the type of property and circumstances.
How to calculate effective gross income
Let's first consider a simple example, and then we'll look at a more complex calculation of effective gross income.
A simple outline quote for a single tenant property might look like this:
In this example, vacancy and credit loss are all shown on one line. In simple estimates like this, the vacancy item is often calculated using a percentage rate, in this case 10%.
The Effective Gross Income above is calculated by subtracting 10% for vacancy and credit losses from the property's potential gross income. In this example, the Effective Gross Income is 100,000 minus 10,000 = 90,000.
For multiperiod pro formas, this calculation is done similarly and repeated for each period in the analysis.
Detailed Effective Total Revenue Calculation
Because the circumstances and characteristics of different types of real estate vary, the pro forma format may actually vary, which means that the calculation of effective gross income itself may also vary.
Consider a multi-tenant office building that is half vacant upon acquisition and has multiple leases expiring during the holding period. For more complex pro formas like this, it is common for absorption and conversion vacancy line items to be modeled on the pro forma. These line items calculate the actual vacancy during the holding period prior to the lease start date (absorption) and the actual vacancy from when a lease expires until the next lease begins (conversion vacancy). This actual vacancy calculation is based on the tenant's contractual lease start and end dates, not on an overall vacancy rate as used in the simple example above. These market lease terms are typically modeled on the pro forma using a market lease profile.
A more complex pro forma line item might look like this:
To calculate effective gross income, we start with the property's potential rental income — the base rent it would earn if it were 100% occupied. For any periods when the space is vacant, we use estimated market-based rents to calculate the potential rental income.
Next, subtract Absorption Vacancy and Turnover Vacancy. Absorption Vacancy equals the market rent used to calculate potential rental income before the lease start date. Similarly, Turnover Vacancy equals the market rent used to calculate potential rental income after the lease ends before the next tenant begins occupancy. In other words, these Absorption Vacancy and Turnover Vacancy items completely offset the market rent during the vacancy period that appears on the Potential Rental Income line.
If you subtract the free rent given to tenants as an incentive to sign a new lease, you will end up with a base rent item, which is the actual base rent that a landlord is expected to collect from a tenant.
Next, add in any reimbursement income from the tenants. Calculating reimbursement income can range from simple to complex, depending on each tenant's lease structure. For example, a tenant may have a simple triple net lease where they are obligated to pay a pro rata share of all expenses. At the other end of the spectrum is a gross lease or full-service lease that requires the landlord to pay all operating expenses. In this case, there is no reimbursement to the tenant. However, modified gross leases are the most common, where both the landlord and tenant each have some responsibility for paying operating expenses.
Next, add in any other income the property receives, such as parking fees or sales revenue. This gives you your Gross Revenue item, which is the total income the property is expected to generate from tenants and other sources.
Next, there is the general vacancy deduction, which is calculated in addition to the actual vacancy calculated in the absorption and turnover vacancy line item. When using the absorption and turnover vacancy calculation, this line item is often omitted. However, a market vacancy rate factor is sometimes used in the general vacancy line item so that the pro forma total vacancy rate is at least as high as the market. For example, if absorption and turnover vacancy is 5% and the market vacancy rate is 10%, an additional 5% vacancy would be shown in the general vacancy line item. It is common for appraisers and lenders to do this when estimating the market value of a property.
You can also view an estimate of credit losses, which are allowances for tenants who don't pay rent. This is usually estimated as a percentage of gross income.
Finally, we calculated effective total income after deducting general vacancies and credit losses from total income items.
Effective Total Income Multiplier
Effective gross income can be used to calculate the gross income multiplier, which is the ratio of the selling price or value of the property to the gross income.
The effective gross income multiplier uses the effective gross income line items on the pro forma as the numerator in the effective gross income formula.
For example, if the sale price of a property was 1,000,000 and the Effective Gross Income was 200,000, then the Effective Gross Income Multiplier would be 1,000,000 / 200,000 or 5.00.
Appraisers may use an effective gross income multiplier along with the net profit margin to estimate the gross capitalization rate. The net profit margin is calculated by dividing the property's net operating income by the property's effective gross income.
This technique is used when strict data requirements cannot be met from sales of comparable properties. If the total proceeds are known from sales of comparable properties, the overall cap rate can be estimated using market average expense ratios, which are readily available to appraisers.
For example, say you know that the market average expense ratio for a particular property type in a particular market is 55%. You have identified comparable properties, but only have potential and effective gross income data. In this case, the comparable property sold for 400,000 and had an effective gross income of 80,000. Using this information in conjunction with the market average expense ratio, you can estimate your overall capitalization rate.
Applying a 55% operating expense ratio to an effective gross income of 80,000 gives an estimated net operating income of 36,000. The effective gross income multiplier is 400,000 / 80,000 or 5.00. The net income ratio is 36,000 / 80,000 or 0.45. Now we can derive an overall capitalization rate from the comparable properties as follows:
So, in this example, the overall rate would be 0.45 / 5.00, or 9.0%. This process can be repeated for each comparable sale identified. An overall capitalization rate can then be estimated by adjusting each of the cap rates derived from the comparables.
Conclusion
In this article, we defined effective gross income, showed how the formula for calculating effective gross income works, and provided a detailed example of how to calculate effective gross income. We used two calculation examples. First, we provided a simple calculation of effective gross income that only considers general vacancy rates and credit loss factors.
We then looked at a more complex example that included vacancies due to absorption and conversion, free rentals, redemption income, and other miscellaneous income. Finally, we discussed a practical way to use effective gross income by calculating the gross income multiplier, which is sometimes used by appraisers to estimate overall capitalization rates when detailed comparable sales data is not available.