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?
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.
STEP 1: Required Rate of Return
Required Rate of Return (RRR) = 11.94%
STEP 2: Year 1 Net Present Value
Year 1 NPV= $625.32
STEP 3: Year 2 Net Present Value
Year 2 NPV= $718.20
STEP 4: Year 3 Net Present Value
Year 3 NPV= $819.79
STEP 3: Year 4 Net Present Value
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
Year 5 NPV= $71,961.11
STEP 6: Add up all the Net Present Values
STEP 7: Substitute formula values
Which means you have accomplished exactly your rate of return for the real estate investment property.
|Gross Rent Multiplier||Cash on Cash Return||Profitability Index||Internal Rate of Return||Debt Coverage Ratio|
|Break Even Ratio||Loan To Value Ratio||Capitalization Rate||Net Cash Flow||Real Estate Risk Management and Metrics|