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 IncomeVacancy 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.

Comments are always welcomed and encouraged! Let me know your thoughts below in the comment section and feel free to retweet this post on Twitter or share on Facebook.

Photo: ShutterBugChef

Khary Reynolds is a real estate investor and freelance copywriter with more than 10 years of experience in developing content for savvy real estate investors and executives that will build trust and credibility within their marketplace and aggressively grow their sales and profitability.

1. The vacancy rate even in this context, still plays a big role in a landlord’s earning power. The gross income will only be complete if vacancy rate stays 0% for a full year, which is almost near impossible with the dwindling economy. But that’s beside the point. Great post by the way. Can’t wait to read the next parts of this post.

• Thanks for the comment John. You are right, the vacancy rate should never be 0%. If the building is 100% occupied, then it is a good possibility that your rents are too low!

2. Good definitions. Very clear and easy to understand!! I actually haven’t heard EGI used … not sure if that is a Canada vs US difference or something I just haven’t been exposed to. Thanks for the explanation. Honestly I think cap rate is the most misunderstood word in commercial real estate. Everyone thinks they understand how to calculate it yet so many people misuse it.

• Thanks for the comment Julie. Yeah, EGI is one of terms that is really technical and most people (i.e. Investors or Brokers) rarely use it, but it is a good term to know just in case. Yeah, the cap rate does get misused pretty often, especially when someone is trying to sell their property for way too much! 🙂

3. Yes for me one of the bigger indicators is the TREND REPORT. This report will tell you the performance of the property TODAY and whether the property is stable,improving,or declining with it’s numbers.

A famous line by other brokers listing apartments.We have tax returns for 2008 but the seller just hasn’t gotten around to 2009 yet. Don’t worry these properties are doing great!!

Bottom line if the seller is dumping because of a headache then that will be reflected in the sales price for the buyer to take on and correct those issues.

• Thanks for the comment Joel. You’re right, you definitely have to look out for the progression of the property. There is a reason that the seller is selling the property and it is our job to figure out why. If you believe everything the broker tells you, you are sure to purchase someone’s headache at a premium cost.

4. Yakeisha Tillett on

Khary- I truly appreciate you taking the time to thoroughly cover these definitions with great examples. One question I have, as I am a newbie to commercial RE and have yet to do my first deal, for vacancy calculations do you use what is the existing vacancy for the property at the time of consideration to purchase, or a preset standard like 5-10% factored in? Thanks!

• Hey Yakeisha,

Thanks for the comment. In terms of the vacancy rate it really depends on the location of the deal. If it is in an area that I really know, then I will use the existing vacancy rate OR the vacancy rate for the area, whichever is higher. So for example, if a property has a vacancy rate of 5%, but from experience or by talking to a trusted property manager, I know the vacancy rate in the area is 7%, I will use 7%. If I do not know the area very well, I will use a 10% vacancy rate and work the numbers according to this vacancy. If a property has a vacancy rate higher than 10%, then I will just use the property’s existing vacancy rate. Hope that helped. Let me know. Thanks again.

5. This is exactly what I am needing. I am going to print this off and put on my office wall!

6. Great post! Its good to start off with the fundamentals : )

7. Khary, thanks for the post and helping me understand the basic vocabulary for my Investing. Don