If you are considering triple net (NNN) lease investing, you may be wondering what the difference is between the profitability index and net present value and how these calculations could influence your decision. In this article, we’ll share the difference between them and how to calculate both.
What is the Profitability Index?
The investment profitability index (PI) is a calculation that presents a preliminary evaluation between the potential costs and profits of an investment. The goal is to achieve a profitability index or ratio greater than one, which indicates a profitable investment.
The profitability index is the ratio between the present value of future cash flows and the initial investment.
The Profitability Index Method of Measurement
The profitability index method of measurement is used to decide on a potential investment’s desirability. A PI measurement of 1.0 is likely the lowest desired number; it is the break-even point. If the PI is below 1.0, it signifies that the present value of the investment is lower than the initial investment. Therefore, the investment should be avoided. If it’s over 1.0, this indicates a solid investment.
How to Calculate the Profitability Index
To calculate the profitability index of a NNN property investment, divide the present value of the property’s future cash flows by the initial investment. As noted, if the PI is over 1.0, then the profitability is positive, but if it is below 1.0, then the investment will probably fail.
- Present Value of Future Cash Flows/Initial Investment Required
Let’s say you buy a Dollar General for $1 million cash. It has a present value of future cash flows of $250,000. The PI would be 1.25.
This is the same as 1 + net present value/initial investment required.
The Advantage of the Profitability Index Method
The profitability index method is a fast way to calculate the potential profit from an investment to inform you of whether to proceed with the transaction. It is a jumping-off point as you consider all the factors of the property and whether it is likely to be profitable.
The Downside of Using the Profitability Index Calculation
While using the profitability index is an efficient way of ranking NNN investments in terms of desirability, it does not take into account the interest rate on a commercial mortgage or the initial capital expenditure, and therefore, may not provide an accurate indication of cash flow.
Profitability Index Rule of Thumb
The investment profitability index rule of thumb is that when the value of the PI is bigger than 1.0, the investment would be more attractive. Generally, a PI that’s greater than one will correspond to a positive net present value calculation.
What is Net Present Value?
Net present value (NPV) is a measurement of an investment’s profitability based on the assumption that a future dollar does not have the same worth as today’s dollar. Just as the profitability index considers an investment property’s future cash flow, so too does the net present value. However, the net present value gives you the dollar difference, while the profitability index provides the ratio.
The net present value accounts for the time value of money. If the NPV is positive, the investment will most likely be profitable.
Net Present Value Method of Measurement
The net present value is one of the primary methods of measurement for evaluating an investment. The NPV method reveals how profitable a NNN investment will be in comparison to alternatives, such as multi-tenant commercial real estate.
When an investment has a positive net present value, it indicates a solid investment that should most likely be accepted. If negative, it should be avoided. When weighing several positive NPV options, those with lower discount values (less risk) should be accepted.
NPV Discount Rate
When using the NPV method of measurement, it is essential to choose a proper discount rate, which may be derived from the cost of the capital required to invest. It can also indicate the interest rate the Federal Reserve charges banks for short-term loans or the rate used to discount future cash flows in a discounted cash flow (DCF) analysis.
When the NPV is lower, this indicates higher risk, which leads to a higher discount rate. Investments with higher risk (gross lease real estate) have a higher discount rate than lower-risk investments (absolute NNN lease real estate).
How to Calculate Net Present Value
Let’s look at an example NPV calculation. A NNN property requires a $1 million investment. Its current worth with a revenue stream is $1,100,000. The NPV would be $100,000, while the profitability index ratio would be 1.10. This demonstrates that the project is likely to be successful.
- NPV Single Investment: Net Present Value = Present Value – Investment
- NPV Multiple Investments: CF (Cash flow)/(1 + r)t
Here, “r” indicates the discount rate, while “t” is the time of the cash flow. Let’s look at both examples.
- A single NNN investment: $1,500,000 – $300,000 = $1,200,000 NPV
- Multiple NNN investments: $200,000/1.1 = $181,818
The Advantage of Using the NPV Calculation
The advantage of using the NPV calculation is that you can assess all future cash inflows and outflows of an investment with the discount rate to get an estimated dollar amount of the projected profitability of the investment.
The Downside of Using the NPV Calculation
The downside of the NPV method is its relativity. The calculation relies on assumptions and estimates of unknown investment costs and unpredicted expenditures that go unaccounted for at the time of investing, leaving room for error.
Additionally, a NNN property investment may hold a corresponding profitability index with separate investments and a different dollar return, which contributes to a dominant NPV.
The Net Present Value Rule of Thumb
The net present value rule of thumb is that investing in something with an NPV greater than zero means your earnings and wealth should increase. If your NNN investment were to have a neutral NPV (which would be unusual, but not impossible), future immeasurable benefits, such as the real estate value at the time of resale, could make the investment worthwhile.
When to Use the Investment Profitability Index & Net Present Value Methods of Measurement
Even though the profitability index and net present value appear to give you the same end result, understanding the difference between them can help you compare NNN properties quickly and easily. Because the profitability index is a ratio, it is absolute: it tells you the proportion of dollars returned to dollars invested (instead of a specific dollar amount). The PI allows you to compare the profitability of two properties without regard to the amount of money invested in each.
NPV, on the other hand, suggests exactly how profitable an investment will be in comparison to alternatives and provides an actual cash flow estimation in dollars.
When to Use the Profitability Index Calculation
If you’re making multiple investments, the profitability index calculation may provide for faster decision-making in that it delivers a percentage of return on the investment per property. The profitability index shows how much value you would gain by investing. In the above example, you can quickly see that each dollar gives you $1.10.
When to Use the Net Present Value Calculation
Though they seem similar, there is a slight difference between PI and NPV in that the PI does not suggest the amount of the actual cash flows, where NPV does. The NPV requires a bit more understanding of discount rates and cash-flows to perform the calculation, but it may provide better insight by giving the total expected return in dollars.
When the PI and NPV are used in harmony to invest in multiple properties, this may help you diversify with the most success.
To Wrap it Up – Now You Know How to Calculate Investment Profitability Index & How to Calculate the Net Present Value, Which do You Use?
To get the best idea of whether the property you’re interested in will be a good investment, the NPV is one of the most desirable evaluation models. It is the first and foremost measure of investment evaluation, compared to other methods, such as determining the rate of return, payback period, internal rate of return, and profitability index. In fact, the profitability index is related to net present value where the value presents an absolute measure, and the index presents a relative measure.
If you would like to learn more about these calculations in relation to NNN lease property investing, feel free to contact a Westwood Net Lease Advisor today. Our no-obligation consultations are free, as is our buyer representation. 314-997-5227