Effective Gross Income (EGI) is the realistic annual income a property is expected to generate before any operating expenses are paid. Think of it as the money you actually anticipate collecting from an investment property, not the pie-in-the-sky number you'd get if every unit was rented out every single day to a perfect, always-paying tenant. That fantasy number is called Potential Gross Income (PGI). EGI brings things back down to earth by subtracting an allowance for Vacancy and Credit Loss—covering empty units and tenants who unfortunately don't pay their rent. For a value investor, EGI is a critical first step in property analysis. It cuts through sales hype and provides a sober, conservative estimate of a property's true earning power. It's the foundation upon which more important metrics, like Net Operating Income (NOI), are built, ensuring you're valuing the property based on what it's likely to produce, not what it could produce in a perfect world.
Calculating EGI is a straightforward process of starting with the maximum possible income and then adjusting for real-world imperfections.
First, you determine the Potential Gross Income (PGI). This is the total annual rental income the property would produce if it were 100% occupied for the entire year, with all tenants paying their rent in full and on time.
Next, you add any other income the property generates. This is money earned from sources other than rent. Common examples include:
Let's say our 10-unit building generates an extra €5,000 a year from laundry and parking fees. Our total potential income is now €125,000.
This is the most important step. No property stays 100% full forever, and occasionally, a tenant will fail to pay. You must account for this. A common practice is to use a percentage of the PGI. This Vacancy and Credit Loss rate can be based on the property's history, the average for the local market, or a conservative estimate if you're a cautious investor. A 5% to 10% rate is a typical starting point.
The complete formula is: EGI = (Potential Gross Income + Other Income) - Vacancy and Credit Loss Let's finish our example using a 5% vacancy and credit loss rate on the PGI portion:
As you can see, the EGI of €119,000 is a much more dependable figure for analysis than the initial PGI of €120,000 or the total potential of €125,000.
EGI isn't just a line item on a spreadsheet; it's a mindset that promotes disciplined investing.
Relying on PGI is a classic rookie mistake. It inflates a property's appeal and can lead to overpaying. EGI forces you to be realistic about potential Cash Flow. By acknowledging that things can and do go wrong (like vacancies), you're building a Margin of Safety directly into your calculations. This protects your downside and is the hallmark of intelligent investing.
EGI is the essential bridge to calculating Net Operating Income (NOI), one of the most important metrics in real estate. The formula is simple: NOI = EGI - Operating Expenses. Without an accurate EGI, your NOI will be wrong. A correct NOI is fundamental for:
Imagine two nearly identical apartment buildings for sale, both priced at $1 million.
Despite having a lower “potential” income, Building B has a significantly higher effective income. The value investor, focusing on the realistic EGI, immediately sees that Building B is generating more cash and is likely the far superior investment. EGI helped uncover the true story behind the numbers.