The effective gross income is the rental income minus considerations, such as not being paid on time, vacancy rates and other factors which may alter the actual rent collected by the landlord.
To calculate the effective gross income, begin by using the potential gross income-that is the maximum a property can generate- and add to this to all other income generated from the building-and subtract this by losses and vacancy rates.
The purpose of calculating the effective gross income, aside from of course determining the income of the property is to calculate the value of an investment property. An investment property’s value is based on how much money the property generates. Knowing the gross income is not enough to determine the value of a property. One must know the expenses related to an investment property to calculate its true value.
Costs of Vacancy
Each building will experience brief or sustained periods when every unit within the building is not being rented. Vacancy costs refer to the period where the building is unoccupied and therefore not collecting rental income. This must be accounted for when determining the value of a property. Whether the property is or is not being rented out, the property owner must continue to make mortgage payments and property taxes. Clearly, it is understood why the costs of vacancy are so important.
Also, finding a tenant takes time and money. It takes time to show the property to prospective tenants and money to do background checks, credit screening, etc. This also must be accounted for when calculating the effective gross income.
In the second paragraph above, we talked about other income that is generated. This includes but is not limited to:
Why Effective Gross Income is Important
Effective gross income is used to determine the true income of a property after all expenses to find the property’s cap rate. The cap rate is the property’s rate of return after expenses. Expenses include property taxes, costs of repairs, paying property managers, and others. Investors use effective gross income all the time when considering whether to purchase an investment or not.
For example, assume a 10-unit property generates $100,000 a year in revenue. Each unit making $10,000 a year with $20,000 per year in additional income. The total income equals $120,000. Assume this same building has a vacancy rate of 10%, then the property effective gross income is $110,000. This is derived from adding $100,000 in income from rents collected to $20,000 per year in additional income, totaling $120,000. Take this $120,000 and subtract 10% from its vacancy rate and you have the effective gross income.