How Profitability Index Measures Your Investment Property Return
Profitability index is one of the lesser-known investment property measures of return primarily because it commonly gives way to it's more popular 'kissing-cousin', net present value (NPV).
Both methods apply the element of time value and discount a rental property's future cash flows to arrive at their present value than weigh that value against the investor's initial cash investment.
The difference between both approaches is that net present value finds the dollar amount difference between the discounted cash flows and initial cash investment, whereas profitability index finds the ratio.
For example, let's say that you're going to initially invest $100,000 cash to acquire a rental property anticipated to produce a revenue stream with a present worth of $110,000. The NPV would be $10,000 (the dollar difference); the profitability index, on the other hand, would be 1.10 (the ratio).
On the surface, of course, the index appears to simply provide another way to express the same result (which, in one sense, is somewhat true). But there's also a significant difference worth understanding that can help you make more prudent investment decisions.
Because the index is a ration, it's not sensitive to the amount of the investment. In other words, it tells you the proportion of dollars returned to dollars invested rather than the amount. So you're given the advantage to easily compare the profitability for any number of real estate investment opportunities that require different initial investments.
Present Value of all Future Cash Flows / Initial Cash Investment
To make the calculation requires the amount of initial cash investment (i.e., down payment, closing costs, etc.), all the future revenues produced by the property during a particular holding period (e.g., five years), and a designated discount rate. That is, the rate of return you require to cover an opportunity cost of capital, expected inflation over the holding period, and a premium for the risk associated with the investment.
Afterward, all future revenues are discounted at that rate to establish their present value and then divided by the amount of the initial investment.
A sample is provided in the image above from my iCalculator solution so you can preview the calculation. (Click the image to enlarge).
Here's how to interpret your results.
- An index of 1.0 means you achieved your desired rate of return exactly
- 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
The profitability index is just one of many approaches investors take when they're trying to make a prudent real estate investing decision. By itself it offers little. But when taken in conjunction with other investment methods, the index can be a helpful tool indeed.
Here's to your real estate investing success!