If you read my previous post, 3 Things You Need to Know to Invest in Commercial Real Estate, you know that I stated that it is critical that investors know the vocabulary of commercial real estate. So, in order to expand on that concept, I wanted to do a series of posts discussing the different definitions of commercial real estate and why they are important to your success.
In this post, I want to discuss the three terms that relate to the income of a property.
1.) Gross Income
By definition, Gross Income is the total amount of income that could be generated by the rents of your property over the course of a year, assuming that the property is fully occupied. The terms Gross Rental Income or Gross Scheduled Income may also be used instead of the term Gross Income. Regardless of the term used, you need to know the maximum amount of income that can be generated by the rents of a property before vacancies and credit losses.
For Example, you are looking at a 10 unit Apartment building that are all 2 bedroom units. From your research, you gather that 2 bedroom units in this part of town are renting for $1000 a month.
Therefore, the numbers would look like this:
2 bedroom units at $1000 a month X 10 units = $10,000 a month in rental income
Monthly rental income of $10,000 X 12 months = $120,000
From this example, your Gross Income or (Gross Rental Income or Gross Scheduled Income) would be $120,000, because this is the Maximum amount of income that you can receive from the rents generated by the property.
Once you have determined the Gross Income, now you need to account for the vacancies within the property.
2.) Vacancy Rate
The vacancy rate is the percentage of all the rental units that are vacant in relation to the total amount of units in the property.
The formula for Vacancy rate is the total vacant units ÷ the number of total units
For example, using the same property information above, the total number of units would be 10, because their are 10 units in the apartment building. If two units are vacant, then the vacancy rate would be 20%.
Formula: 2 (total vacant units) ÷ 10 (the number of total units) = .2 or 20%
3.) Effective Gross Income (EGI)
Effective Gross Income, or EGI for short, serves as the baseline for which you will use in calculating the earning capacity of the property. This is the figure you will use to subtract operating expenses from, and consequently determining the Net Operating Income (NOI) of a property.
Effective Gross Income is calculated by taking the Gross Income and subtracting the vacancy and collection costs, plus adding any additional income that the property may generate outside of rental income, i.e. Laundry, Vending Machines, Parking, etc.
The formula for the Effective Gross Income is as follows:
Gross Income – Vacancy Costs (vacancy rate (%) x income = $ amount) – Credit Loss (i.e. collections, evictions, etc) = Effective Gross Income (EGI)
For example, using the same property information above:
Gross Income: $120,000
(minus)Vacancy Rate (20%): $24,000
(minus) Credit Loss (2%): $2400
(plus) Additional Miscellaneous Income (Laundry, Parking, etc.): $3500
=Effective Gross Income (EGI): $97,100
You need to understand how to calculate the effective gross income of a property as this will serve as your baseline for subtracting operating expenses and calculating the Net Operating Income of the property.
This post is the first in a three part series discussing the vocabulary and formulas needed to analyze commercial property. In the next post we will talk more about Operating Expenses and Net Operating Income. When you combine all of these concepts together, you will have a better understanding of how a property is operating and whether or not is suitable for your investment goals.
If you have any questions, we can carry the conversation over into the comments below so please let me know your thoughts and comment below.
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