{"id":97976,"date":"2018-04-03T11:10:34","date_gmt":"2018-04-03T17:10:34","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=97976"},"modified":"2021-03-16T13:52:37","modified_gmt":"2021-03-16T19:52:37","slug":"underwriting-multifamily-calculate-egi","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/underwriting-multifamily-calculate-egi","title":{"rendered":"Intro to Multifamily Underwriting: 5 Steps to Calculate Effective Gross Income (EGI)"},"content":{"rendered":"<p><span style=\"font-weight: 400;\">Quite commonly you hear this<\/span> phrase &#8220;real estate is all about the numbers.&#8221;\u00a0This phrase is one of the more eloquent falsehoods in real estate. I suppose we could thi<span style=\"font-weight: 400;\">nk of this statement as truth, but we\u2019d have to qualify the statement with:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\"><span style=\"font-weight: 400;\">Whose numbers?<\/span><\/li>\n<li style=\"font-weight: 400;\"><span style=\"font-weight: 400;\">Which numbers?<\/span><\/li>\n<li style=\"font-weight: 400;\"><span style=\"font-weight: 400;\">When numbers?<\/span><\/li>\n<li style=\"font-weight: 400;\"><span style=\"font-weight: 400;\">Where numbers?<\/span><\/li>\n<li style=\"font-weight: 400;\"><span style=\"font-weight: 400;\">Why numbers?<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">You get the point.<\/span><\/p>\n<h2>If Not the Numbers, What <em>Is<\/em> it About?<\/h2>\n<p><span style=\"font-weight: 400;\">I want you to imagine yourself as a painter. There you are. It\u2019s spring in Paris. Romance is in the air. Multifamily is on your mind&#8230;<\/span><\/p>\n<p><span style=\"font-weight: 400;\">You\u2019ve got your apron and your beret on. You look the part. You are an artist. You\u2019ve got your palette in your left hand and a brush in your right. Ready, set, go.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But what comes first\u2014mixing of paints on the palette or establishing a vision of what you want to paint? You know that it is within your ability to mix those paints in a billion different ways. Whatever shade you need, you can create. But is that where the process begins, or is mixing paints an outcome of your vision of what is to become your painting?<\/span><\/p>\n<h2>It\u2019s All About the End<\/h2>\n<p><span style=\"font-weight: 400;\">I promise you that whichever facet of life you examine, you will find the same phenomenon\u2014everything begins with the end in mind. The choices you make while raising your kids are all a function of whom you imagine your children becoming in the end. Your diet and exercise regime is all about how you see yourself 30 years from now. How you treat your friends today is all about how you see them treating you when roles are reversed tomorrow. Your marriage\u2014don\u2019t even get me started on that one! Your behavior around investing has to be teed-up by your vision of the final destination. <\/span><\/p>\n<p><em><strong>Related:<\/strong> <a href=\"\/renewsblog\/underwriting-multifamily-deals\" target=\"_blank\">The Most Important Things I\u2019ve Learned About Underwriting Multifamily Deals<\/a><\/em><\/p>\n<p><span style=\"font-weight: 400;\">You see, you \u201cmix your paints\u201d only after you know which shades you need, and you will only know which shades to use once you clearly see in your mind\u2019s eye that which is to become the painting.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Once you see the end, you can walk it back to arrive at all of the building blocks you\u2019ll need to actually get there.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In real estate, this works the exact same way. Whether you buy a building or not is a function of being able to project what life with that building will be like. It\u2019s the story. Now, once you understand the story, you use numbers like a painter uses paint.<\/span><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-97312\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/03\/where-are-the-notes.jpg\" alt=\"where-are-the-notes\" width=\"702\" height=\"336\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/03\/where-are-the-notes.jpg 702w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/03\/where-are-the-notes-300x144.jpg 300w\" sizes=\"auto, (max-width: 702px) 100vw, 702px\" \/><\/p>\n<h2>An Important Distinction<\/h2>\n<p><span style=\"font-weight: 400;\">Real estate is not about the numbers any more than paintings are about the paint. Real estate is about the story, and numbers are there simply to tell this story. <\/span><\/p>\n<p><span style=\"font-weight: 400;\">The important distinction to make is that people who understand storytelling in real estate are able to manipulate the numbers much the same way a painter is able to manipulate paint to tell whatever story suits them. And if you make the mistake of focusing on the numbers as your entry point to the underwriting, those numbers will tell you the story that someone else wants you to see, not the truth.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The story is the truth. Start there. The numbers are there to represent the story. But always start with the story.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In the following few articles, I\u2019ll attempt to present to you the story, at least in the very broad strokes. Each time I sit down to underwrite a new opportunity, I methodically put numbers into a spreadsheet that contains about eight pages. Each page is there to address a specific part of the story. Today, we are going to begin with page one\u2014Stabilized P&amp;L. <\/span><\/p>\n<h2>Stabilized P&amp;L<\/h2>\n<p><span style=\"font-weight: 400;\">I call this page <\/span>my &#8220;back of the napkin&#8221; underwriting. The reason I refer to it as &#8220;back of the napkin&#8221; is because while it tells a complete story in many ways, this page is static in nature. Of course, all of us know that any realistic story in real estate cannot be static\u2014things change every week, month, year. A good underwriting model has to address all of these dynamics. But we have to start somewhere, and for me, it\u2019s the Stabilized P&amp;L on page one of the underwriting.<\/p>\n<p>There are several questions being asked at this first stage, most importantly: If this asset were operating to its best capacity, what will that look like in terms of all of the line-items in the P&amp;L?<\/p>\n<p><span style=\"font-weight: 400;\">We are painting a picture of stabilized operations here. Naturally, we are not buying a stabilized asset, and it will take money and time for it to get there. But if it were there today, what would that picture look like?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s look at some of the line items to consider.<\/span><\/p>\n<p><em><strong>Related:<\/strong> <a href=\"\/renewsblog\/multifamily-renovations-bang-buck\/\" target=\"_blank\">3 Easy Multifamily Renovations That Give the Best Bang for Your Buck<\/a><\/em><\/p>\n<h3>Income<\/h3>\n<p><span style=\"font-weight: 400;\">Literally nothing is simple in this game. Even a simple concept of income is something to discuss. There are different types of income. All of them are discounted and synergized into what\u2019s known as effective gross income (EGI). This is essentially your expected collected top-line number. But the process of arriving at the EGI involves several steps:<\/span><\/p>\n<h3>Step 1: GSR<\/h3>\n<p><span style=\"font-weight: 400;\">GSR stands for gross scheduled rent, and this is easy enough to understand. You simply price gross rent for each of the unit types and multiply by the number of units in the type. So, if you never had a vacancy, never had an eviction, never offered any discounts, etc., this would be how much rental revenue comes in.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Now, how you price these rents is crucial for a lot of reasons. Being off by $10\/month is a big deal. But that\u2019s for another time.<\/span><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-96878\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/02\/guy.jpg\" alt=\"\" width=\"702\" height=\"340\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/02\/guy.jpg 702w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2018\/02\/guy-300x145.jpg 300w\" sizes=\"auto, (max-width: 702px) 100vw, 702px\" \/><\/p>\n<h3>Step 2: Economic Losses<\/h3>\n<p><span style=\"font-weight: 400;\">It<\/span>\u2019s nice to imagine that everything is perfect all of the time, but nothing ever is. So, in our underwriting, we have to allow for imperfections. Th<span style=\"font-weight: 400;\">e following subsection of the und<\/span>erwriting is called &#8220;economic losses,&#8221; and it includes the following line-items: <a href=\"\/renewsblog\/2014\/08\/05\/loss-lease-definitive-guide\/\" target=\"_blank\">loss to lease (LTL)<\/a>, physical vacancy, concessions, credit loss (ba<span style=\"font-weight: 400;\">d debt), and non-revenue units.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">We could spend a long time discussing what these are exactly, and we could spend an even longer time talking about the why, when, and how of each of the above economic losses. We could represent these as percentage or per door dollar costs, and there are accepted norms which we baseline on. Remember, you are telling a story, though, so whether you use, percentage or dollars, you must first understand the story\u2014the why, when, and how\u2014and then boil it down to the numbers. This is an article of its own. <\/span><\/p>\n<p><span style=\"font-weight: 400;\">But understand this\u2014even though you are not necessarily writing checks to cover these items because they manifest in the form of lost revenue, they are just as real as any other cost\/expense. Economically speaking. these inhibit your bottom line by discounting your top line.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">You won\u2019t hear many people talk about these items. However, I have to tell you that not paying due respect to the economic loss items will cost you lots of money. I should also tell you that prudently, the minimum stabilized economic loss I\u2019d recommend you use is something around 8 percent. I won\u2019t tell you that you couldn\u2019t outperform. But it\u2019s not safe to underwrite anything less in my opinion.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This means, boys and girls, that even a stabilized property, one functioning at capacity, will lose 8 percent of its revenue before you pay a single bill. Let me say that again, so you get it:<\/span><\/p>\n<p><em><span style=\"font-weight: 400;\">Even a stable property will lose about 8 percent of its top line before you ever write a single check for a single service or cost. Internalize this! <\/span><\/em><\/p>\n<h3>Step 3: Effective Rental Income<\/h3>\n<p><span style=\"font-weight: 400;\">Thus, you take your GSR from Step 1 and discount it by the amount of your economic loss, and this gets you to the effective rental income. Effective income is income after the economic losses.<\/span><\/p>\n<h3>Step 4: Auxiliary Revenues<\/h3>\n<p><span style=\"font-weight: 400;\">In most income-producing assets, the income is comprised of actual rents and auxiliary revenues. One of the biggest auxiliary revenues has to do with utilities. Whether <a href=\"https:\/\/www.biggerpockets.com\/forums\/432\/topics\/501936-whats-the-concept-of-using-rubs\" target=\"_blank\">RUBS<\/a> or a simple fixed bill-back is utilized, the utility income gets its own line item in our underwriting. There are accepted norms for this line item, but this is very subject to everything from asset class to location, so telling the correct story is very important here.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Aside for utility income, there may be some additional income streams\u2014things such as pet fees and deposits, late fees, insufficient funds fees, early termination fees, laundry income, parking income, storage income, and more. We combine those into another line item in this section. And, true to form, while there are national baseline statistics for these, it\u2019s all about your specific story.<\/span><\/p>\n<h3>Step 5: Effective Gross Income<\/h3>\n<p><span style=\"font-weight: 400;\">By adding the auxiliary revenues from Step 4 to the effective rental income from Step 3, we arrive at the effective gross income (EGI). This is the income we would expect our asset to be capable of generating on an annual basis.<\/span><\/p>\n<h2>Wrapping Up for Now<\/h2>\n<p><span style=\"font-weight: 400;\">So, in the beginning of this process, we sat out to answer the question,\u00a0<\/span><i><span style=\"font-weight: 400;\">what do stable operations look like in this asset in terms of the P&amp;L?\u00a0<\/span><\/i><span style=\"font-weight: 400;\">We now have identified the story of the income, be it in very broad strokes. Once the income is coming in as it should, and once the economic losses are under control and normalized, this is what the income side of this asset\u2019s equation looks like.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">We will obviously need to make adjustments to these figures later in the underwriting process to cater to the fact the today the subject asset is not stabilized. But this comes later. First, we need to figure out the expense side of our Stabilized P&amp;L, and we will do that in the next article. \u00a0<\/span><\/p>\n<p><a href=\"https:\/\/www.biggerpockets.com\/real-estate-investment-calculator?utm_source=renewsblog\" target=\"_blank\"><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-91220\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2017\/08\/blog_ads-02.jpg\" alt=\"\" width=\"700\" height=\"85\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2017\/08\/blog_ads-02.jpg 700w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2017\/08\/blog_ads-02-300x36.jpg 300w\" sizes=\"auto, (max-width: 700px) 100vw, 700px\" \/><\/a><\/p>\n<p><em>Any questions about this process?<\/em><\/p>\n<p><strong>Comment below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Once income is coming in as it should and economic losses are under control and normalized, this is what the income side of the asset\u2019s equation looks like.<\/p>\n","protected":false},"author":810,"featured_media":77028,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4252],"tags":[],"class_list":["post-97976","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-deal-analysis"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/97976","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/810"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=97976"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/97976\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/77028"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=97976"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=97976"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=97976"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}