February 24, 2018
By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
Effective Gross Income is much simpler than it sounds, but also a lot more important than it may sound. It is the actual—and I mean actual—amount of money an investment real estate property has grossed in the past 12 months. Keep in mind that realtors when selling an investment or commercial property may brag that the property is fully rented and show you a pro forma or projection based on the property being full. The number they are talking about is likely the gross potential income. Let’s say this number is $150,000. Yes, if the property stayed 100% occupied the entire year it would gross this much. But, in reality this property averages a 15% vacancy since there are just too many vacant units on the market. The Effective Gross Income is 85% of the annual gross rent on the property being 100% full or $127,500. It is important to use the effective gross income in figuring out the cap rate or value of the property, not the monthly potential income. Ideally, you want to use the effective gross income, which is the past 12 trailing months of actual income. Be sure to include all the miscellaneous income such as late fees, deposits forfeited, pet fees, cleaning fees, etc. This will give you an accurate number for Effective Gross Income.
Why is Effective Gross Income so important?
First of all, lenders use the effective gross income to determine the gross income of the property and how much they can lend you. They will often base this on market occupancy and actual expenses. Secondly, when you are buying an investment property it is a must. In doing your due dilligence, you will ask the seller to provide the current rent roll. This will show the property’s potential income based on who is occupying the units this month. If there is a realtor, it is likely that the marketing flyer has used this for the gross income in the pro forma and have based the value of the property on this. But should you base the value of the property on the current month’s gross income? What if the property for whatever reason had low occupancy for a long time and a few months prior to putting it on the market the seller did whatever they could to fill all the vacant units. Maybe they did not check credit or references and put anyone in there. Just because tenants are listed on the rent roll does not mean they are paying rent. This is a good example of when effective gross income is so important. So you ask the seller for the past 12 months income and expense statement. From this you figure out that the property had high vacancy. You go back to the seller and say, “ok, I see that the gross income of the property is showing 100% occupancy today and so does your pro forma. But based on the past 12 months the effective gross income is a lot less, and therefore the property is worth less. The seller insists that with good management the property will gross this much and is not willing to lower the price. In this example, the effective gross income of the property is a red flag to perhaps look for another investment property. Thirdly, when figuring out a gross rent multiplier for an investment property you are interested in buying you do not want to base this on potential gross income, but effective gross income.
An Example of Calculating Effective Gross Income (4 steps):
Before we do that, let’s define a few terms:
i. Potential Gross Income - the maximum amount of rental income that can be made from a piece of real estate property without any credit or vacancy losses.
ii. Bad debt allowance – an allowance for uncollected rents from tenants who occupied an apartment.
iii. Vacancy allowance – an allowance for how long the unit stays vacant between tenants. Let’s say that each unit of a 20 unit building is unoccupied an average of a half month a year, and rents are $500 per month. The vacancy allowance for the year is ½ of $500 = $250 X 20 units = $5000.
Step 1 - Figure out what the annual potential gross income is. Let’s say that the monthly rent for an apartment complex is $10,000. To figure the annual potential gross income, multiply the $10,000 by 12 and you get $120,000.
Step 2 - Figure out other income the property is earning. This can include income from laundry machines, vending machines, fees from parking, fees from bad checks, etc.
Step 3 - Add the total annual amount of other income (Step 2.) to annual potential gross income (Step 1). Let’s say your annual total other income is $50,000 and your annual potential gross income is $120,000. The sum of both is $170,000.
Step 4 - Subtract the vacancy allowance and bad debt allowance from the income total (Step 3). This figure is the effective gross income.
By Terry Painter/President Apartment Loan Store and Business Loan Store