Effective Gross Income (EGI)

What is Effective Gross Income (EGI)?

Effective Gross Income (EGI) is a critical metric that is utilized in real estate to assess the true potential revenue of a rental property. EGI is the maximum rental value realizable before deducting any operating expense.

The effective gross income is the real income property can return. The reason behind its accuracy is that EGI accounts for the rental revenue of a property, the additional non-rental income it returns, and the vacancy and credit costs it may incur.

The gross rent of a property is not the only revenue it generates. As a result, real estate investors may benefit from various non-rental revenue streams. 

Non-rental revenue streams may include but are not limited to fees charged on additional services provided in properties.

In addition, it is not efficient to only account for the operational costs a property requires. As a result, there are costs we don't account for in the income statement but should consider when evaluating the performance of real estate investments.

For example, Occupancy rates and collection inefficiencies are cost indicators that landlords account for when valuing their investments' efficacy.

EGI is an insightful metric for real estate investors since it shows them a real return on their properties. Ultimately, each investor looks for risk-free indicators that project actual cash inflows to assess their profitability.

Formula for Effective Gross Income

To understand EGI well, it is very crucial to understand its variables. EGI is calculated by adding the gross potential rental revenue and other income generated by properties, then subtracting vacancy and credit costs:

Effective Gross Income (EGI) = Gross Rental Income + Other Property Income - Vacancy Costs - Credit Costs

Gross Rental Income

It is the maximum rental income a property can generate. When accounting for the gross rental income, it is assumed that 100% of the properties are rented for their maximum deserved rents. 

For example, if you own a dorm complex consisting of 50 rooms and each room is rented for $1,000 a month, your gross rental income would be 50*1000= $50,000, assuming all rooms are rented for the desired price.

Other Property Income

Landlords do not always rely on the rent income their properties provide. They can also benefit from other non-rental revenue streams. These revenues include but are not limited to:

• Parking permits
• Laundry service fees
• Security fees
• Gym fees
• Late Fees
• Vending machines revenues

Vacancy Costs

Real estate investors acknowledge that even in the best scenarios, occupancy rates of their properties may not reach 100%. In other words, they will not be able to rent all their properties for a certain period. 

The costs associated with unoccupied properties are considered vacancy costs and must be subtracted from the gross rental income since they fail to generate any revenue for landlords.

Usually, vacancy rates alternate between 7% and 10%, depending on a couple of variables.

Moving back to the dorm complex owner's example, his vacancy cost would be 50,000*10% = $5,000, assuming a 10% vacancy rate. 

Credit costs

Credit costs occur when landlords cannot collect their full rent from residents. Even when properties are successfully rented, payment inefficiencies must be considered.

Credit costs occur when a tenant fails to pay for their rent or when they pay for the rent partially.

Effective gross income (EGI) vs. Net operating income (NOI)

EGI leads you to accurate revenues generated by properties. However, to get to the net income contributed by the property, you should subtract its operating expenses.

Net Operating Income (NOI) = EGI - Opearting Expenses

Landlords incur multi-operational expenses to keep their properties running. We can classify operational costs according to the renting process properties pass through:

1. Acquiring customers: The first stage is reaching out to tenants to advertise properties. Costs incurred in this stage include all advertising expenses and bonuses earned by brokers, if any.
2. Renting Properties: When renting a property, real estate investors incur costs throughout the renting period. Such costs include utilities and salaries expenses required to keep a property running.
3. Terminating contracts: After the contract period is due, landlords incur renovation and maintenance costs to equip their properties for future investments. Operational expenses may also include depreciation and amortization expenses on tangible or intangible assets owned by landlords.

Examples of EGI and NOI

You are considering acquiring Mega Mall, a mall with 100 commercial stores. Stores are rented yearly for $30,000 each. Due to your experience in the commercial real estate industry, you estimate the mall to face a vacancy rate of 10%. 

You also assume that 5% of tenants will pay 50% of the rent and another 5% will fail to pay at all. Other various non-rental revenues historically account for $100,000 per year. 

Finally, the mall's fixed operating cost is $1,000,000 a year, with a variable cost of $10,000 for each rented store.

Task 1: Calculate the mall's effective gross income.

Task 2: Calculate the mall's net income.

Task 1 solution

Gross rental income = 100 x $30,000 = $3,000,000 

Other non-rental income = $100,000

Vacancy Cost = 100 x 10% x $30,000 = $300,000

Credit Cost = (90 x 5% x $30,000 x 50%) + (90 x 5% x $30,000) = 67,500 + 135,000 = $202,500

Note: We accounted for only 90 stores in credit costs since 10% will not be occupied.

EGI = 3,000,000 + 100,000 - 300,000 - 202,500 = $2,597,500

Task 2 solution

Fixed operational cost = $1,000,000

Variable operational cost = 90 x $10,000 = $900,000

Net Income = $2,597,500 - $800,000 - $900,000 = $897,500

How to Increase Effective Gross Income?

After understanding its formula, we can now introduce ways to increase EGI on properties:

1. Increase gross rent income

The first step to be taken is increasing the rent of properties. To increase the rent, you should increase the willingness-to-pay of tenants on your property. You can do so by adding more value to it.

For example, if you own houses, you can renovate their design to make them more luxurious or modern, depending on the needs of your targeted tenants. Doing so will make them willing to pay more to rent the houses.

2. Increase your non-rental income

You need to think of innovative ways to provide services other than the rent that can generate extra revenues. Such services may complement the rent service.

For example, if you own a dorm complex, you can include a gym and charge extra income. Also, you can start a kitchen that prepares daily meals for residents.

3. Decreasing vacancy cost

It is hard to predict vacancy costs as they depend on several variables. However, you can control them by investing in risk-free real estate investments.

You can, for example, invest in busy cities that show high demand for properties for rent, or you can invest in trendy and desirable real estate properties.

The bottom line, you need to ensure a high demand for your properties to decrease your vacancy rates as much as possible.

4. Decreasing Credit Costs

Even if there is demand on your properties, you will still encounter the risk that some tenants may fail to pay the rent fully or partially. Credit costs mainly arise because of the tenant's inability to pay their rent.

Thus, to decrease your credit costs, you need to ensure tenants enjoy financial security. You can do so by targeting higher middle class or rich cities and locations or by being selective in accepting tenants who can pay the rent and show a healthy credit history.

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