Profitability Index: How It Can Help You Make Prudent Real Estate Investing Decisions

The Profitability Index (PI) is a method real estate investors use to measure whether or not a rental property's estimated future cash flow benefits will achieve the rate of return they desire on their initial cash investment.

Actually, profitability index is similar to net present value (NPV) in this regard given that both apply the element of time value and discount a rental property's future cash flows and than weigh that value against the investor's initial cash investment. NPV, however, computes the difference between the present value (PV) of future cash flows and initial cash investment and thereby results in a dollar amount, whereas PI computes, not the difference between the two amounts, but the ratio.

Therefore, a significant advantage to PI is that the index is a ratio and therefore is not sensitive to the dollar amount of the investment. As a result, real estate investors are able to easily compare the profitability for any number of real estate investment opportunities regardless of how much cash each requires as an initial investment.

The Formula

Step-by-step:

1. Calculate your initial cash investment.
   Compute the total dollar amount of your down payment, closing costs, appraisal and inspections fees, etc.
2. Designate a discount rate.
   Specify 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.
3. Calculate the present value of all future cash flows generated during your estimated holding period.
   Do this by "discounting" each future cash flow back at your designated rate of return (i.e., discount rate).
4. Do the math.
   Divide the total present value of those discounted future cash flows by the total amount of your initial investment.

Example:

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.

Schema:
CF0 100,000
CF1 3,500
CF2 4,000
CF3 4,500 + 150,000
Profitability Index: 100,000 ÷ 122,566 = 1.2257

Interpretation:

• 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

Result:

Based on the data submitted for this specific rental income property, the 1.2257 profitability index computed indicates that this real estate investment will exceed your desired goal of a 10% rate of return.

Rule of Thumb

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

Profitability Index (PI) is included in both these ProAPOD solutions: