Profitability index allows those making investings in real estate to measure investment return on a rental income property much like net present value (NPV), but with the following difference.
NPV takes the sum of present values (PV) of all future cash flows and subtracts the amount of initial investment to determine the dollar amount difference between PV and initial investment. Profitability index finds the ratio between PV and initial investment.
How to Calculate
Profitability Index = Present Value of all Future Cash Flows / Initial Cash Investment
Profitability Index vs Net Present Value
The advantage of profitability index when measuring real estate investing opportunities is that it allows you to compare two real estate investment opportunities that require different initial investments. Because, unlike using NPV to find the dollar amount difference between PV and initial investment, the index is a ratio (i.e., it finds the proportion of dollars returned to dollars invested) and therefore is not sensitive to the amount of the investment. As a result, when the present worth of cash flows equals your initial investment exactly the NPV would be zero (because there is no dollar amount difference) and the profitability index would be 1.0 (because there is no proportionate difference).
Let’s take a look at an example so you can see the difference between these real estate investing measures.
Assume you are valuating two apartment buildings as potential investments. Property A requires a cash investment of $150,000 and you estimate the PV of all its future cash flows at $160,000. Property B requires a cash investment of $90,000 and you estimate the PV of all its future cash flows at $99,000.
The net present value for Property A is $10,000 (160,000 – 150,000 = 10,000) and the net present value for Property B is $9,000 (99,000 – 90,000 = 9,000). In this case, net present value makes Property A seem to appear more profitable than Property B because it has the greater NPV (i.e., 10,000 vs 9,000).
However, look what happens when you calculate the profitability index for both properties. The index for Property A is 1.07 (160,000 / 150,000 = 1.07), whereas the index for Property B is 1.10 (99,000 / 90,000 = 1.10). Therefore the profitability index reveals that Property B is actually more profitable than Property A (1.10 vs 1.07).
Here’s how to quickly interpret the profitability index to see whether or not you meet you meet your investment goal. A profitability index of 1.0 means you have exactly achieved your desired rate of return (i.e., the price you need to pay for the property based upon its future cash flows discounted at your rate of return is exactly right). An index greater than 1.0 means that you’ve exceeded your goal. An index less than 1.0 means that you failed to achieve your goal.
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