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Profitability Index

By Juan Cabrera, MBA realbench.net

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The Profitability Index measures the Cost-Benefit of a proposed real estate investment property.

The profitability index is an alternative way of stating the net present value (NPV), also known as benefit/cost ratio. The Profitability Index is a great indicator of how good of an investment you are making. It's especially useful if you can only invest a limited amount on a real estate investment property. You can calculate the Profitability Index for multiple real estate investment possibilities, and the one that has the highest profitability index value is the one where you should focus your resources.

A profitability index of 1.0 means you achieved exactly your goal rate of return, greater than 1.0 means you have exceeded your goal rate of return, and below 1.0 means you failed to reach your goal rate of return.

How to calculate the Profitability Index?

	Present Value Of Future Cash Flows
Profitability Index	= --------------------------------------
	Initial Cash Investment

Example:

An investor purchases a real estate investment property and puts $20,000 in down payment and closing costs. The net cash flows for year 1, 2, 4 and 5 are forecasted to be $700, $900, $1,150, $1,375, $1,500 and $125,000 respectively. And the investor is planning on selling the real estate investment property on the fifth year for $125,000.

Initial Investment	: $75,000
Year 1 Cash Flow	: $700
Year 2 Cash Flow	: $900
Year 3 Cash Flow	: $1,150
Year 4 Cash Flow	: $1,375
Year 5 Cash Flow	: $1,500
Year 5 Sale Proceeds Cash Flow	: $125,000

STEP 1: Required Rate of Return

Required Rate of Return (RRR) = 11.94%

STEP 2: Year 1 Net Present Value

	$700
Year 1 NPV=	-------------
	1
	(1 + 11.94)

Year 1 NPV= $625.32

STEP 3: Year 2 Net Present Value

	$900
Year 2 NPV=	-------------
	2
	(1 + 11.94)

Year 2 NPV= $718.20

STEP 4: Year 3 Net Present Value

	$1,150
Year 3 NPV=	-------------
	3
	(1 + 11.94)

Year 3 NPV= $819.79

STEP 3: Year 4 Net Present Value

	$1,375
Year 4 NPV=	-------------
	4
	(1 + 11.94)

Year 4 NPV= $875.61

STEP 5: Year 5 Net Present Value

Year 5 Cash Flow= Rental + Sale
Year 5 Cash Flow= $1,500 + $125,000
Year 5 Cash Flow= $126,500

	$126,500
Year 5 NPV=	-------------
	5
	(1 + 11.94)

Year 5 NPV= $71,961.11

STEP 6: Add up all the Net Present Values

Discounted Cash Flow =	Year 1 NPV
	Year 2 NPV
	Year 3 NPV
	Year 4 NPV
	Year 5 NPV
	----------
	Total Discounted Cash Flow

Discounted Cash Flow =	$625.32
	$718.20
	$819.79
	$875.61
	$71,961.11
	----------
	$75,000

STEP 7: Substitute formula values

	Present Value Of Future Cash Flows
Profitability Index	= --------------------------------------
	Initial Cash Investment

	$75,000
Profitability Index	= --------------------------------------
	$75,000

Profitability Index

= 1.00

Which means you have accomplished exactly your rate of return for the real estate investment property.

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Last Updated May 28, 2010