From potential rent to effective gross income
Income property is valued on what it collects. Start with potential gross income — every unit rented every month — then subtract vacancy and collection loss and add other income.
Worked example: 120 units at $1,300 a month, 9 vacant, plus $30,000 a year of laundry and parking income.
- Vacancy rate = 9 ÷ 120 = 7.5%
- Potential gross income = 120 × $1,300 × 12 = $1,872,000
- Vacancy and collection loss = 7.5% × $1,872,000 = $140,400
- Effective gross income = $1,872,000 − $140,400 + $30,000 = $1,761,600
Traps: stopping at $1,872,000, forgetting the $30,000, or adding other income without deducting vacancy.
Net operating income and value
Subtract operating expenses from effective gross income. Debt service is never deducted in arriving at NOI — it is a financing cost, not an operating cost.
Continuing, with $879,580 of operating expenses, $600,000 of annual debt service and a 6.5% capitalization rate:
- NOI = $1,761,600 − $879,580 = $882,020
- Value = NOI ÷ cap rate = $882,020 ÷ 0.065 = $13,569,538
Subtracting debt service first gives $282,020 ÷ 0.065 — the classic error. Capitalizing effective gross income instead of NOI overstates value.
Gross rent multiplier
Derive the multiplier from a sale, then apply it.
- GRM = price ÷ gross annual rent = $200,000 ÷ ($750 × 12) = $200,000 ÷ $9,000 = 22.22
- Subject value = 22.22 × ($900 × 12) = 22.22 × $10,800 = $239,976, about $240,000
Keep multiplier and rent on the same annual footing; do not round 22.22 to 20.
Percentage and per-square-foot rent
A percentage lease charges base rent plus a percentage of sales above a breakpoint. With $3,000 monthly base rent, 5% over a $720,000 breakpoint and $900,000 of sales:
- Base rent = $3,000 × 12 = $36,000
- Percentage rent = 5% × ($900,000 − $720,000) = 5% × $180,000 = $9,000
- Total = $45,000
Natural breakpoint check: $36,000 ÷ 0.05 = $720,000. Applying 5% to all sales ignores the breakpoint.
Commercial rent is quoted annually per square foot: $1,500 × 12 ÷ 1,000 sq ft = $18,000 ÷ 1,000 = $18.00 per square foot per year. Answering $1.50 gives the monthly rate.
A comparative rental market analysis compares location, size, age, amenities, condition and services, then adjusts for differences.