How to Calculate a Rental Property's Profitability Index
A profitability index (PI) is a method real estate investors use to compare the initial cash required to make the investment to the present value (PV) of all its estimated future cash flow benefits.
Profitability index is similar to net present value (NPV) as a method of measuring investment return in that both apply the element of time value, discount a rental property's future cash flow, and each weighs that value against the investor's initial cash investment.
Where they differ is that net present value is the difference between the PV of all future cash flows and initial investment, and PI is the ratio. For instance, an NPV might result in a number like $100 (a dollar amount), a profitability index might result in a number like 1.2 (a ratio).
PI = Present Value of all Future Cash Flows / Initial Cash Investment
- Calculate the total dollar amount of your initial cash investment (i.e., down payment, closing costs, appraisal and inspections fees, etc.)
- Designate a discount rate. That is, the rate of return you require on the cash invested that will cover your opportunity cost of capital, all expected inflation over your estimated holding period of the property, and a premium for the risk associated with the investment.
- Calculate the present value of all future cash flows generated during your estimated holding period by "discounting" them back at your designated rate of return (i.e., discount rate).
- Divide the total present value of those discounted future cash flows by the total amount of your initial investment.
- 1.0 means you achieved your desired rate of return exactly
- > 1.0 means that you've exceeded your goal
- < 1.0 means that you failed to achieve your goal
Let's say that you're going to initially invest $100,000 cash to acquire a rental income property anticipated to produce a revenue stream of 3,500, 4,000 and 4,500 over three years (plus resale proceeds in the third year of $150,000) and you require a 10% rate of return on your initial investment.
- CF0 100,000
- CF1 3,500
- CF2 4,000
- CF3 4,500 + 150,000
100,000 ÷ 122,566 = 1.2257
Rule of Thumb
A significant advantage to PI is that the index is a ratio, and therefore is not sensitive to the dollar amount of the investment. This enables real estate investors to easily compare the profitability for any number of real estate investment opportunities regardless of how much cash each requires as an initial investment.
Of course, profitability index is just one of many approaches investors take when trying to make a prudent real estate investing decision, and by itself it offers little. But when taken in conjunction with other investment methods and returns, the index can be a helpful tool.
Here's to your real estate investing success!
So You Know
ProAPOD Executive 10 software automatically computes profitability index and includes the results in the appropriate real estate analysis reports. iCalculator online allows you to quickly compute PI based upon any data you enter into the appropriate form.