The formula looks like this:

Gross Potential Rent + Other Income – Vacancy Costs – Credit Loss = Effective Gross Income

In order to understand what exactly is going on in this equation, let’s break down each section of this formula.

Gross potential rent is the total amount of rental income an investor would earn if 100% of the units in their investment property were occupied at full market rental rates. This figure is hypothetical by design, as it is unlikely that a property would ever be 100% occupied. We can determine the gross potential income by simply multiplying the total number of units in an investment property by the market rent for each unit.

This is any other form of income an investment property produces outside of rents.

This can be income made by coin laundry, vending machines, parking fees, RUBS and more.

Vacancy costs are the loss in income (both rental income and other income) accrued when a unit is unoccupied. This is also known as the vacancy rate.

Typically this can be determined by looking at historical data from the property and market or by running comps (also known as comparables). It can also be determined by reviewing a property’s rent roll.

This is when a unit is occupied, but the tenant isn’t paying rent according to the lease.

This can be a situation where only partial rent is being paid or where a tenant isn’t paying anything.

RELATED: 6 Creative Ways to Get Rid of Bad Tenants

Suppose we have a 10-unit apartment building. The market suggests each unit should rent out for $1,000 per month.

In this scenario, the gross potential rent would be $120,000 per year:

10 Units x $1,000 per unit = $10,000 per month

$10,000 x 12 months = $120,000 per year

This 10-unit building also generates an additional $400 per month, which is $4,800 per year from the coin laundry operation on site.

So, to determine the EGI, our first step would be to combine these two figures for a total of $124,800 per year.

$120,000 (gross potential rent) + $4,800 (other income) = $124,800

Now, let’s say only 8 of the 10 units are currently rented and one tenant is in the process of being evicted and is three months late on rent.

Due to these two vacancies, we have a loss of $2,000 per month in rent and $100 from the money we would have made from coin laundry.

$400 from coin laundry / 8 units = $50 per unit

$50 per month x 2 units = $100

So our total vacancy cost is $2,100 per month or $25,200 per year.

Additionally, we have a credit loss of $3,000 from the tenant who hasn’t paid in three months.

Based on this example, here is our effective gross income for this 10 unit apartment building:

$120,000 (Gross Potential Rents) + $4,800 (Other Income) – $25,200 (Vacancy Cost) – $3,000 (Credit Loss) = $96,600 in Effective Gross Income

Effective gross income is important to factor because it helps investors determine whether or not a property makes enough positive cash flow to cover expenses.

Said a different way, EGI is important because it informs investors how much income the property will actually generate and is a crucial metric in analyzing a deal.