Follow the case
Where does the rental income go?
Select a year, then a cash-flow stage to see its calculation.
Cash remaining at each stage
Annual dollarsBars share the same scale: the selected year’s gross rental revenue. Choose a row to show the work.
View the six-year summary
Operating cash flow excludes the sale and reserve refund. These enter the final year only in “Sell and measure returns.” All displayed dollars are rounded; calculations retain full precision, with annual income taxes rounded to the nearest dollar.
Discussion: Why does Year 2 cash flow fall so sharply?
Rent falls 5% while vacancy rises from 7% to 14%. Net rental revenue falls about 12.2%, even before other changes. Lower operating expenses partly offset the decline, but higher property taxes, tenant improvements, and leasing commissions add pressure. The mortgage payment stays fixed.
Isolate one mechanism
Who funds this year’s capital spending?
Change the opening reserve and follow the same planned CapEx.
Annual contribution stays at 4.5% of gross rental revenue. The reserve earns no interest.
This experiment changes the reserve and unlevered cash available. Loan size, taxes, and investment returns are outside this view; the other views retain the original reserve.
Reserve balance through the hold
Before refund at saleThe reserve account
Capital spending is unchanged
Funding the CapEx bill
Why a higher adjusted NOI does not mean free CapEx
Prefunding moves cash into a restricted account at acquisition. Later withdrawals can preserve annual distributable cash, but the money was committed earlier. When the reserve is exhausted, only the uncovered portion of CapEx reduces adjusted NOI.
Uncovered CapEx = max(0, CapEx − beginning reserve − annual contribution)
This is an undiscounted funding identity. Timing, financing, and opportunity cost still matter. The case loan finances 75% of purchase price plus the initial reserve; changing that reserve in a complete investment model would also change the loan and equity.
Discussion: Does prefunding eliminate capital costs?
Try “No prefunding,” then inspect Year 1. The annual contribution covers part of the bill and operating cash funds the remaining amount. Next try “Partial funding”: the initial $10,000 covers part of that shortfall. Compare the cash available with the original case.
Understand the two tax components
How is the gain on sale taxed?
Find the gain above adjusted cost basis, then separate depreciation recapture from property appreciation.
This setting is shared with Section 4. It changes sale price and taxes while the property’s cost basis stays fixed.
First, calculate the gain
Net sale price minus adjusted cost basis
How is adjusted cost basis calculated?
Capitalized TIs and CapEx increase basis. Depreciation of the building, TIs, and CapEx reduces it. Leasing-commission amortization is separate.
Then, apply each tax rate
Two parts of the same gain
Depreciation recapture
Depreciation lowered the tax basis during ownership. This part of the gain reflects those prior deductions.
Property appreciation
The remaining gain is the net sale price above acquisition cost plus capitalized improvements.
Tax on depreciation recapture + tax on property appreciation
Displayed dollars are rounded; the total uses unrounded values. The 25% and 15% tax rates are fixed teaching assumptions.
Discussion: Why does the exit cap rate affect the two components differently?
One assumption, one comparison
How much of the return comes from selling?
Change only the exit cap rate. Operations, financing, and the original reserve stay fixed.
Year 7 adjusted NOI stays at . Selling costs are 2% of gross price.
From property value to equity proceeds
At saleSale income tax combines depreciation recapture and appreciation taxes. .
What arrives in Year 6?
After tax, to equityThe next owner’s forward income sets the sale price at the end of Year 6. It is not an additional Year 7 distribution to this investor.
The investor’s cash-flow timeline
Annual dollars, after taxShow exact cash flows and return formulas
Discussion: Why does a 0.5-point cap-rate increase matter?
Explain the change using the sale-price denominator, then trace the reduction through selling costs, sale taxes, equity proceeds, and the return measures.
Case assumptions and teaching conventions
- Acquisition and financing: $6.7 million purchase, $225,000 initial reserve, and a six-year hold. The loan funds 75% of purchase price plus the reserve, at 7% interest with 30-year monthly amortization. Equity also pays 1% loan points.
- Operating cash flow: NOI is measured after the reserve contribution. Adjusted NOI deducts TIs, leasing commissions, and CapEx not covered by reserve withdrawals.
- Tax assumptions: 21% on operating taxable income, 25% on depreciation recapture, and 15% on property appreciation. Building depreciation spans 27.5 years; TIs and leasing commissions use one year; CapEx and loan points use seven years, with remaining loan points deducted at sale.
- Sale and experiments: Sale value uses forward adjusted NOI of $793,076.91, with 2% selling costs. The reserve experiment stands alone. Sections 3 and 4 share the same exit cap rate and retain the original reserve and financing.