When assessing the performance of your commercial real estate investments, there are many different return-on-investment metrics at your disposal. Examples include nominal returns, real returns, cash-on-cash return, and more. Each method has its place, but which one should you use, and when?
This guide will unpack some of the most valuable financial metrics used by commercial real estate investors to measure return on investment: Nominal return and its relatives, after-tax and real rate of return.
What is Nominal Rate of Return?
The nominal rate of return is the return generated by an investment without adjusting for any negative factors like inflation, taxes, or other expenses.
It’s a really simple way to calculate return on investment and easily compare the performance of different investments across your portfolio, whether they’re stocks, bonds, or real estate assets.
Nominal return is a high-level indicator which you could think of like a gross salary before all the cost-to-company deductions are accounted for.
Thus, it’s useful for high-level comparisons, and a starting point before choosing to go deeper. However, what you are actually gaining (your real return) would be relatively lower than the nominal return.
Since it’s a relatively quick calculation, the nominal return is useful for simple comparisons of the performance of assets in a commercial real estate portfolio, regardless of the inflation rate or differing time spans for each investment.
It’s a good initial formula to apply, giving a high-level view before delving deeper into the real rate of return and after-tax rate of return.
How is Nominal Return Calculated?
Nominal rate of return is calculated by subtracting the original investment value from the current market value, and further diving this figure by the original investment value.
Put simply: You’re working out the growth or decrease in value of that investment, as a percentage of the original investment value.
Example 1: You Invest in a Fund and Want to Know the Returns After a Year
Let’s say you invest $100 000 into a mutual fund. After a year, your investment has grown to a total of $110 000. The current investment value is $110 000, and the original investment value was $100 000. Your investment has grown by $10 000.
The nominal rate of return for this investment is: $10 000 / $ 100 000 = 10%.
Why Nominal Rate of Return is Important
Just like knowing the gross salary of a potential job is important before getting to grips with the take-home amount, the nominal rate of return can help you to quickly and easily compare the performance of different real estate investments across a portfolio before getting to grips with their individual costs.
To get a more detailed view of how your investments are performing, it’s necessary to take inflation, taxation, and other expenses into account. This is where the after-tax rate of return and the real rate of return are valuable.
Nominal Return vs. After-Tax Rate of Return
Nominal return doesn’t consider the expenses incurred in achieving that return. Tax is one of these expenses.
The amount of tax you pay on your investment can be affected by several factors:
- Your tax bracket/s
- The type of asset
- The length of time since you acquired the asset
This means that your tax rate per asset might vary between investments, or that you may be taxed differently to another investor with the same investment with the same nominal rate of return.
Different investments might also have different tax rates applied to them. For example, in most cases, municipal bonds are tax-exempt while income from corporate bonds is taxed.
Your after-tax rate of return can give you a more realistic view of your investment’s performance as it takes those tax deductions into account when calculating the return. It can differ significantly from your nominal rate of return.
Nominal Return vs. Real Rate of Return
Another significant factor to consider when assessing the performance of your CRE investment is inflation.
Has your purchasing power grown through your investment? Or has your investment just kept up with inflation, or worse, declined over time as goods and services have become more expensive?
Adjusting the nominal rate of return for inflation will determine your real rate of return, and thus give you a more accurate indicator of the profitability of your investment.
You can calculate the real rate of return by subtracting the inflation rate from the nominal interest rate. For example, if your investment has grown by 10%, and the inflation rate is 4%, then your real rate of return is 6%.
Example 2: Calculating the Real Rate of Return on your Investment
Let’s look at the example we used earlier, where you made a 10% nominal return on your original investment of $100 00 in a mutual fund over a year.
If inflation for those 12 months was 7%, then your real rate of return is 10% - 7% = 3%. Therefore, your purchasing power has increased by 7%.
The only time your nominal rate of return might be higher than or equal to your real rate of return would be in times of zero inflation or deflation.
These times are rare, although the last example of deflation in the US occurred between 2007 and 2008 in a period economists referred to as the Great Recession.
Compared to the nominal return, calculating the real rate of return will give you a clearer view of how your investment is performing in relation to purchasing power.
It’s also a useful tool to compare the performance of real estate investments over different time periods, or different local currencies, where rates of inflation can vary.
Limitations of the Nominal Rate of Return
When making decisions on your investments, be wary of using the nominal rate of return only. It’s useful in that it gives a high-level indication of profitability, but it does not accurately reflect your actual earnings.
It doesn’t consider:
- Taxation
- Inflation
- Other expenses incurred in the generation of your returns
For this reason, it should be taken with a pinch of salt, and used in conjunction with other return indicators to get a truer picture of how your real estate investments are actually performing.
Final Thoughts on Nominal Returns
The nominal rate of return is great in that it’s a relatively easy, uncomplicated formula to calculate and compare returns on investments.
As with every indicator, it has its appropriate uses. When evaluating your portfolio, remember to also consider the after-tax rate of return, and the real rate of return, to understand performance more accurately, and identify opportunities.
Understanding nominal, after-tax, and real rates of return supports a more strategic approach to commercial real estate portfolio management and investment decision-making.
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