When any investor is considering the purchase of commercial real estate, one of the most important things they will do as part of their pre-purchase due diligence process is to create a “proforma” projection of a property’s income and expenses over a defined period of time. Although the proforma for each property is somewhat unique, they all follow the same general patterns.
In this article, we are going to describe one important proforma calculation known as Effective Gross Income or “EGI” for short. We will describe what it is, how it is calculated, and why it matters when creating a proforma. By the end, the goal is for readers to be able to incorporate this knowledge into their own pre-investment due diligence process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. Before making any purchase, we invest a significant amount of time and resources into the development of an investment proforma that always includes an Effective Gross Income line item. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is a Proforma?
In order to understand Effective Gross Income, it is first helpful to understand what a proforma is and why it matters to a commercial real estate investment.
The easiest way to think about a proforma is as an investor’s best estimate of a property’s future income and operating expenses. Typically, income and expenses are projected over a planned holding period – usually 5-10 years – and the resulting calculations help investors calculate their potential return on investment assuming everything goes according to plan.
Again, the style and content of a proforma can vary widely by property type, investor, and experience, but they all follow a somewhat similar pattern. First, investors attempt to project a property’s income based on rental rates and potential vacancy. Then, they subtract operating expenses like property taxes, insurance, and maintenance.
Income less operating expenses equals a key operating metric known as Net Operating Income or “NOI,” which is a particularly important number when it comes to calculating a property’s fair market valuation.
Within the proforma income calculation there is a line item known as Effective Gross Income.
What is Effective Gross Income?
Effective Gross Income is an investment property proforma line item that incorporates all sources of income less an allocation for vacancy and bad debt
Calculating Effective Gross Income
As the description suggests, a property’s Effective Gross Income is calculated as:
EGI = (Potential Gross Rental Income + Other Income) – Vacancy Allowance and Bad Debt
In order to understand how this calculation works, it is helpful to break down each component.
Potential Gross Rental Income
“Potential” Gross Rental Income is the top line revenue that a property could produce assuming that all units are full and leased at market rates. For example, suppose an investor is evaluating a 10 unit multifamily property and the market rent for each unit is $1,000 per month. In this scenario, the potential gross income is (10 * $1,0000) $10,000 per month or $120,000 per year.
Rent isn’t always the only source of income for a property. For example, a multifamily rental property could produce non-rental income from things like laundry machines, vending machines, pet rent, late fees, storage units, parking, or application fees. For a large property, these sources of “Other Income” can add up to be a material amount.
Vacancy Allowance and Bad Debt Expense
In an ideal scenario, a property would be completely full and all of the tenants would pay their rent on time. Unfortunately, this is not always the case.
To account for vacant units, a proforma typically includes some deduction that represents the amount of income lost due to units being empty. This number is expressed as a percentage of the Potential Gross Income and is usually in the range of 5% – 7% on a stabilized basis.
Bad debt expense is the cost associated with tenants who refuse to pay their rent and the effort taken to recover it. For example, these costs could include legal fees and the write offs of unpaid rent.
To illustrate how this calculation works, the example above is expanded.
Example of Effective Gross Income Calculation
In the example above, the property was 10 units and each had a monthly rent of $1,000. So, the Gross Potential Rent is $120,000 annually.
In addition, assume that the property charges monthly pet rent and parking fees that add up to a total of $20,000 annually.
Assume that it is estimated that there will be a vacancy rate of 5% on the property, which represents 1 unit being empty for 6 months of the year. The dollar equivalent of this percentage is (5% * $120,000) $6,000. Also assume that the property has a history of bad debt expense of $5,000 annually.
With these numbers in mind, Effective Gross Income can be calculated as $129,000 (($120,000 + $20,000) – ($5,000 + $6,000)).
This is the starting point for creating the rest of the Proforma line items.
Why Investors Should Understand EGI
As described in the previous section, EGI is important as a starting point for the creation of the rest of the Proforma.
Most notably, real estate investors would subtract projected operating expenses from EGI to get to Net Operating Income, which is the key metric used to determine a commercial property’s value.
To continue the example above, it has been estimated that EGI is $129,000. Now assume that operating expenses are $65,000, which means that the resulting NOI is $64,000 ($129,000 – $65,000).
With the NOI known, investors can apply a “capitalization rate” or cap rate for short that is determined from sales of comparable properties in the same market. In this example, assume a 7% cap rate, which means that the property has an estimated market value of $914,285 ($64,000/7%).
Effective Gross Income and Real Estate Syndications
Although the math used to create a proforma and calculate net operating income is relatively simple, there are a number of assumptions that must be made to project proforma income and expenses over a multi year period. These assumptions must be based on realistic expectations for how things may play out in the future. Although they are educated guesses, it takes many years of experience and dozens of deal transactions to create a reasonable proforma. Lenders and investors rely on the proforma being accurate and often rely upon them to make financial decisions.
For these reasons, it may be a good idea for individual investors to partner with a professional, experienced, commercial real estate investment firm to deploy capital. In a typical scenario, the firm does all of the hard work and research needed to create a proforma, purchase the asset, and manage it while individual investors contribute capital but take an otherwise passive role. This way, the individual can leverage the experience and expertise of the investment firm while earning a return for their fractional ownership of the property.
Summary of Effective Gross Income in Commercial Real Estate
A proforma is a projection of a property’s income and expenses over a defined period. In a real estate purchase, they are often created by investors as a way to estimate their potential return in a deal.
Although proforma are unique to the property for which they are being constructed, they all tend to follow a similar pattern in the line items included.
One of the line items, Effective Gross Income is a metric that attempts to incorporate a property’s potential rental income, other income, and loss to vacancy and/or bad debt.
As a metric, Effective Gross Income is important because it serves as a starting point for the calculation of other key metrics like Net Operating Income, cash flow, and property value.
Creating a multi-year proforma requires a detailed set of assumptions that are typically most accurate after years of experience and dozens of deal repetitions. For this reason, it may be a good idea for individual investors to partner with a professional investment firm to construct a proforma.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.