There's big money-making potential with an investment rental property. However, determining how much you'll actually make isn't as simple as multiplying the monthly rent by 12. To understand your true cash flow, you'll need to keep an eye on your effective gross income (EGI) in relation to your net operating income, which is what you're left with when you pay maintenance fees, property tax, and any other expenses.
How to determine the value of your rental
The effective gross income (EGI) is the combination of your annual potential gross income and other property revenue minus your vacancy allowance. This is an important figure when considering the sale price of a property. You'll need it to determine the operating expenses and resulting net operating income to see if the ratio works for your bottom line.
Let's look at an example: You're considering the purchase of an investment property containing 10 apartments, with each being rented out at $1,500 per month.
$1,500 x 10 units = 15,000 x 12 months = $180,000
The $180,000 in gross rent is your potential gross income. This is what your income will be if all units are occupied at all times during the year.
However, as a property investor with a bottom line, you can't rely on that gross potential income figure. You need to factor in the cost of having vacancies and/or tenant debt at some point. The average vacancy rate in the U.S. is 7%. To make the math in our example easier, let's raise that to 10%. That means out of your 10-unit building, one unit will be vacant at any given time.
$1,500 x 9 units = $13,500 x 12 = $162,000
When you subtract that vacant unit and its yearly rent, you are left with $162,000 -- your effective gross income.
The longer you own a property, the better you will understand its vacancy and unpaid rent trends. But even if you're the luckiest investor in the world and maintain a 100% occupancy rate year after year with tenants who pay on time every month, it's wise to subtract vacancy costs from your rental income (don't forget about that bad debt allowance) and bank on that lower figure instead as your EGI.
When it comes to determining your net operating income, the EGI is an important number. And there are ways of making it bigger.
Other sources of property income
There are ways of increasing your effective gross income -- and the property's value -- that don't involve raising the rent or building another level of units. These include services, amenities, and other add-ons that you charge your tenants to use. These income-generating sources get added to the equation from above and are also calculated as part of your effective gross income.
Let's say you have a small fitness center on the premises and you charge tenants $150 a year to use it. If five of your residents become members, add that cash on to your EGI:
$150 x 5 = $750
$750 + $162,000 = $162,750
$162,750 is your effective gross income. Again, this is the total income you expect to have when you calculate rent (minus vacancies and tenant debt) and add on any additional revenue from your property.
Granted, $750 doesn't seem like a lot in the grand scheme of things, which is why savvy property investors seek additional miscellaneous income streams to keep that EGI on the rise. Here are some examples of how your property can make you more money:
- Parking permits
- Pet fees
- Vending machines
- Rental of common space for private parties
- Furniture rental
- Advertising space (more suited for commercial real estate or high-rise buildings in urban areas)
Depending on which of the above revenue streams are appropriate for your property, you can add thousands of dollars of gross monthly income.
Keep in mind this income approach reflects gross potential income, not net income. After all, it takes money to make money. You'll have to spend money upfront to equip your property with these amenities, as well as factor in the maintenance and/or operating expense for each.
The bottom line
The effective gross income of a property is important for real estate investors to determine whether a property is a good investment. While there are ways to increase the EGI, it's important to make a realistic cash flow forecast based on your operating expenses.