Effective Gross Income (EGI) is one of the income figures that property investors evaluating an income-producing property need to calculate, as an intermediate step for estimating Net Operating Income (NOI), one of the most important measures of the income earning capacity of a property.
The EGI is also needed for the estimation of an important measure of the relationship between property’s income producing capacity and the asking or acquisition price. This measure is the Effective Gross Income Multiplier.
The formula for the Effective Gross Income (EGI):
EGI = Potential Gross Rental Income + Other Income – Vacancy & Bad Debt Allowance
Note that the Potential Gross Income (PGI) includes primarily rental income, but it accounts also for any other income that may be produced by the property, such as income from vending machines, laundry room, parking, etc. The vacancy and bad debt allowance accounts for space/units that remain vacant during the year and, as such, do not actually provide any rental income to the landlord, while bad debt allowances cover any rent that is owed during the year but is not paid by the tenants.
Potential Gross Rental Income = £150,000
Vacancy and Bad Debt Allowance (8%) = £15,000
Other Income = £5,000
Effective Gross Income = 150,000 + 5,000 – 15,000 = 140,000
Thus, in this example, the annual EGI that the property can produce at the time of the purchase is equal to £140,000.
EGI and Investing for Double-Digit Returns
Investors aiming for double-digit returns can not rely on just this indicator to evaluate an investment for several reasons. First, the important property income figure for the investor is the net operating income, which can be calculated from the EGI.
Second, the EGI reflects the gross income that the property can produce at the time of the purchase and not necessarily the income that the property will producing in the future and over the holding period. For example if the property is a multi-tenant property with leases expiring next year and the market rents are falling, then the property’s EGI after a year from its acquisition maybe considerably lower.
Investors aiming for double-digit returns need to carefully assess the most likely cash flows that the property will produce over the holding period through the discounted cash flow model. In this analysis the local market needs to be carefully analyzed in order to determine the most likely changes in rents and value of the property considered for acquisition. Investors aiming for double-digit returns need to target properties with very strong prospects for increasing EGI and NOI, as well increasing property value, over the holding period of the property.