Income Stream Terminology and Components

A. Potential Gross Income (PGI)

The total income a property could generate if fully occupied at market rents, before deducting expenses.  PGI varies significantly across property types, such as multifamily versus commercial, so consider these differences to help readers apply the concepts accurately.

• Contract Rent: Actual rent per current leases; may differ from market rent.  Adjust for concessions (e.g., free rent, tenant improvements, renewal options).
• Market Rent: Rent achievable in the open market for comparable space.  In fee simple valuations, all space is assumed to be leased at market rent.
• Escalation Income: Additional charges from lease clauses passing through expense increases.
• Other Income: Revenue beyond base rent (e.g., parking, equipment rentals, vending, utility resale).

B. Vacancy, Collection Loss, and Rental Concessions

Allowance for income reductions from vacancies, turnover, and nonpayment.  Typically expressed as a percentage of PGI, based on property type, tenant quality, and market conditions.  Stressing the importance of verifying these assumptions with actual market surveys helps readers feel more assured in their underwriting accuracy.

Rental Concessions: Losses from incentives like free rent or moving allowances.
Underwriting Note: Use the higher of actual vacancy or market survey data.

C. Effective Gross Income (EGI)

EGI = PGI minus vacancy, collection loss, and concessions, plus other income.  Mastering this calculation ensures readers feel capable of accurately assessing property income potential, reinforcing their confidence in underwriting practices.

D. Operating Expenses

Recurring costs to maintain the property and produce EGI.  Excludes debt service, depreciation, and income taxes.
Categories:

a)      Fixed Expenses: Do not vary with occupancy (e.g., taxes, insurance).

b)     Variable Expenses: Fluctuate with occupancy (e.g., utilities, maintenance).

c)      Replacement Allowance: Funds for significant repairs or replacements.

d)     Capitalized vs. Operating Expense

·        Capitalized Expense: Added to property basis and depreciated over time (e.g., new roof, pool addition).

·        Operating Expense: Deducted in the year incurred (e.g., roof repair, re-carpet one unit).

e)      Reserves for Replacement

Annual allowance for components with shorter lives than the building (e.g., roof covering, carpeting, equipment, sidewalks, parking areas).  Estimated by prorating the replacement cost over the remaining life.

E. Total Operating Expenses (OE)

Sum of fixed, variable, and replacement reserves.  Excludes debt service, depreciation, and taxes.

F. Net Operating Income (NOI)

EGI minus operating expenses, before debt service and taxes.

G. Debt Service (ADS)

Annual principal and interest payments on the mortgage.  Deducted from NOI to calculate pre-tax cash flow.

H. Pre-Tax Cash Flow (PTCF)

NOI minus debt service, before income taxes.  Also called Before-Tax Cash Flow.

I.  Actual vs. Proforma Income

Actual statements reflect historical performance; pro forma projects future performance.
Lender Beware: Verify pro forma assumptions against appraiser input and rent surveys.

J.  After-Tax Cash Flow (ATCF)

The portion of pre-tax cash flow remaining after ordinary income tax on operations.  Tax liability depends on taxable income, which is reduced by allowable deductions such as interest and depreciation.

K. Depreciation

Loss in property value from any cause, generally the difference between replacement cost and present value.  Depreciation results from deterioration or obsolescence, which begins as soon as improvements are completed.

Types:

• Physical Deterioration
• Curable: Deferred maintenance, wear and tear, cracks, dry rot, and infestation.
• Incurable: Structural issues or age-related conditions that are uneconomical to fix.
• Functional Obsolescence
• Curable: Design flaws or outdated layouts.
• Incurable: Deficiencies that cannot be corrected economically (e.g., no parking for commercial property).
• Economic Obsolescence
• External factors that reduce value (e.g., relocation of the business district, freeway changes, loss of the employment base).

Book Depreciation: Accounting term for writing off the structure and components against taxable income.

L. Real Property

Includes all rights, interests, and benefits inherent in ownership of physical real estate.  An “estate” refers to the degree or nature of interest in land.

M. Personal Property

Movable items not permanently affixed to real estate, such as furniture, fixtures, equipment (FF&E), trade fixtures, machinery, and supplies.

N. Real Property Value vs. Business Value

Properties with operating businesses (e.g., hotels, restaurants, golf clubs, RV parks) may carry business value in addition to real estate value.  For lending purposes, separate real property value from business enterprise value.