Let’s assume you’ve been presented with two outstanding investment properties to purchase. Both can be purchased at a great discount and share similar risk profiles, though property A is significantly more expensive than property B.
You’ve spent hours analyzing this to no avail.
You have done extensive research in the market area. You know what the contract rents are and have verified expenses. After thorough research, you have projected future rents, vacancies, expenses, renovations, and before and after tax cash flow, including the reversion 10 years from now.
You’ve conducted sensitivity analysis and are aware how both properties’ future values may change under different tax treatments, forecasts of expenses, effective income, and changes in home values. Both properties are affected by these changes in similar ways.
You have run simulation analysis to investigate what the property may be worth under different economic conditions. Potential for economic growth and stability are similar in both market areas. Both properties grade extremely well.
What to do next?
You could find out what the internal rate of return is, though there are certain issues including mathematical peculiarities involving multiple answers and a re-investment problem. You could also try a modified version of the IRR.
Because of these issues, you’ve decided to analyze the Present Value and Net Present Value of both properties instead. The problem is, since the initial cost of investment for property A is much greater than B, you are not sure which provides the better value. The NPV is significantly higher for project A but so are the initial costs.
The Profitability Index, our savior
This is where the Profitability Index comes into play. This is the ratio between the Present Value of the anticipated income stream and the cost of the initial investment (PV/Cost). The Profitability Index will give you a clear ranking of investments in certain situations. In this scenario, property A wins out since it has the higher NPV and PI.
However, if you simply take a look at the NPV and the PI, then you fail to account how you would invest the remaining capital. You may not have enough to purchase another property and will have to invest in something else.
This will change the overall risk and expected return of your overall financial portfolio. Unfortunately, investments become more and more complicated as understanding of how different assets work in conjunction increases.
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