Profitability Index vs Net Present Value: Which One Is Better?

Jan 5, 2021 | Blog, Cash Flow, Income Properties | 0 comments

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 answer which is better and how to calculate both.

Profitability Index

The profitability index (PI) presents a parallel between the costs and profits of an investment. 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. 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.

The profitability index is the ratio between the present value of future cash flows and the initial investment.

A profitability index measure of 1.0 is likely the lowest desired number. If it is lower than that, it signifies that the present value of the project is lower than the initial investment. Therefore, the investment should probably be discarded.

Close up view of bookkeeper or financial inspector hands making report, calculating or checking balance. Home finances, investment, economy, saving money or insurance concept

PI Method

Profitability Index formula:

  • Present Value of Future Cash Flows/Initial Investment Required

This is the same as 1 + net present value/initial investment required.

As stated above, a PI of 1.0 means the property’s net present value is greater than its initial investment; 1.0 is therefore the minimum ratio acceptable for the PI. A profitability index greater than 1.0 means that the initial investment goals have been exceeded, and thus the property may be a good investment.

The PI can serve as a substitute for NPV when determining the profits per dollar of investment.

While using the PI is an efficient way of ranking NNN investments in terms of desirability, it does not take into account the interest rate, and may not provide an accurate number for mutually exclusive projects.

Profitability index serves as a tool to classify CRE investments. If the value of the index is bigger, then the investment would be more attractive.

calculating NNN investment value

Net Present Value

Just as the PI considers an investment property’s future cash flow, so too does the net present value (NPV). However, net present value gives you the dollar difference, while the profitability index provides the ratio.

Let’s look at an example of NPV. A NNN property requires a one million dollar 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 Method

NPV is one of the primary methods or techniques for evaluating an investment. It’s important to note when estimating cash flows, an incorrect estimation may lead to deceptive NPV. Additionally, the discount rate is the same for both cash inflows and outflows, which affects lending or borrowing.

NPV Discount Rate

When using this method, it is essential to choose a proper discount rate. Usually, the weighted average cost of capital or the return rate on unconventional investments is used.

If the NPV is lower, the discount rate would be higher. Investments with higher risk have a higher discount rate than lower-risk investments.

NPV Single Investment Formula:

  • Net Present Value = Present Value – Investment

NPV Multiple Investments Formula:

  • 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 an example.

  • Single investment: $150,000 – $10,000 = $140,000
  • Multiple investments: $150,000/1.1 = $136,363

The downside of the NPV method is its relativity. The NNN property investment may hold a corresponding profitability index with separate investments and a different dollar return, which contributes to a dominant NPV.

discover what type of commercial real estate investor you are

Should I Use PI or NPV to Determine Investment Success?

Even though PI and NPV appear the same, 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 amount). The PI allows you to compare the profitability of two properties without regard to the amount of money invested in each.

The profitability index shows how much value you would gain by investing. In the above example, each dollar gives you $1.10. If the net present value appears positive, then the PI would be bigger than 1.0. Otherwise, it would be negative.

Though they seem similar, there is a slight difference between them in that the PI does not suggest the amount of the actual cash flows, where NPV does.

When you use both methods on one property, use caution as they can rate projects differently. However, when used in harmony for multiple properties, they may help you diversify with the most success.

  • If you’re considering one or more property investments, NPV may provide better insight by giving the total expected return.
  • If you’re making multiple investments, the PI may provide for better decision-making in that it delivers a percentage of return on the investment per property.

To Wrap it Up – PI & NPVL: Both Valuable Calculations to Determine NNN Investment Success

NPV is considered one of the most desirable evaluation models for the selection of great investments. 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

Looking To Buy Commercial Property?

Find out why triple-net lease real estate investments should be part of your investment portfolio.