When underwriting a multi-family real estate investment, you will always deal with income as part of your analysis. In fact, income is the most important part of the analysis because without income, there is no service to debt or cash flow. Therefore, understanding the income side of the process is of great importance. For underwriting purposes, income is separated into two categories: Gross Potential Income (GPI) and Effective Gross Income (EGI). See below to understand the difference.
Gross Potential Income (GPI)
Gross Potential Income is maximum income the property can produce. This takes into account the current rental rates and 100% occupancy. For example, for a 16-unit one-bedroom apartment with $475 rent per unit, the GPI is $7,600 per month (16 * $475) or $91,2000 annually.
Effective Gross Income (EGI)
Effective Gross Income, on the other hand, represents the current income of the property. EGI takes into account vacancy. Vacancy, which includes physical vacancy as well as concessions, loss-to-lease and bad debt, subtracts from the gross potential income to arrive at the current income levels of the property.
How to Use This Information
After having reviewed the T12 (trailing 12-month statement provided by the current owner or broker), investors should have a better understanding of the property’s gross potential income as well as effective income after taking into account vacancy and concessions. This information allows investors to understand the following about the property:
- The maximum income earning potential: allows for identification fo the highest amount of rental income the property can produce at market rates and full occupancy
- Any value-add potential of the property: allows for identification of improvements to occupancy or operations (through better collections of rent, offering less concessions, etc.)
- Unknowns or holes: when things do not add up, it will highlight items or concerns that need to be investigated or clarified with the broker.
A challenge that investors will often run into is when working with brokers or unsophisticated sellers, they mistake gross potential income for effective gross income and include items such as vacancyinto the calculation. This makes it difficult to understand the properties income earning potential as well as what is current vacancy. When encountering this challenge, it is advisable to ask as many questions as you can about vacancy and current rents to give you a clear understanding.
Example
Below is a visual of our earlier 16-unit example of Gross Potential Income, Effective Gross Income (after accounting for vacancy) and Net Operating Income (after having taken into account other sources of income, such as laundry or storage).
As you can see, without vacancy, the property could produce $91,200 annually. However, after taking into account physical vacancy and total economic vacancy, the EGI of the property is $80,256. Because there are no other sources of income, total Net Income is also $80,256.
Having a solid familiarity of the asset’s income earning potential is a useful tool for spotting great investment opportunities and possible value-add improvements to operations. These levers allow for equity growth and improved returns for investors.
