Below-the-Line Items in Commercial Real Estate Pro Formas: Tenant Improvements, Leasing Commissions, CapEx, and Replacement Reserves

Key Takeaways

What Sits Below the NOI Line

Every commercial real estate pro forma has a dividing line. Above it sits revenue (gross potential rent, other income, vacancy loss) and operating expenses (property taxes, insurance, utilities, repairs and maintenance, management fees). The difference between effective gross income and operating expenses is Net Operating Income. NOI is the number that drives cap rate valuations, debt sizing, and most of the metrics that buyers, sellers, and lenders use to evaluate a property.

Below that line sits everything else. Tenant improvements. Leasing commissions. Capital expenditures. Replacement reserves. Debt service. These costs do not enter the NOI calculation, but they determine how much cash actually flows to the equity holder in any given year. The gap between NOI and before-tax cash flow (sometimes called cash flow before taxes, or CFBT) is where below-the-line items live.

The distinction matters because NOI and cash flow answer different questions. NOI measures what the property produces as an operating asset, independent of how it is financed and independent of one-time capital costs. Cash flow measures what the equity holder actually receives. A building with strong NOI but heavy below-the-line costs delivers less to equity holders than the capitalized value would suggest. A building with moderate NOI but minimal below-the-line costs can outperform on a cash-on-cash basis.

In institutional underwriting, the below-the-line section of the pro forma is where most of the analytical work happens. Revenue and operating expense projections are important, but they are relatively stable and predictable for stabilized assets. Below-the-line items, by contrast, are lumpy, asset-specific, and sensitive to lease rollover timing. A single large tenant improvement obligation in Year 3 of a hold period can consume an entire year's distributable cash flow. Modeling these costs correctly requires understanding both the individual cost categories and how they interact with the building's lease rollover schedule.

The standard pro forma waterfall runs as follows. Gross potential revenue, less vacancy and credit loss, equals effective gross income. Effective gross income less operating expenses equals NOI. NOI less tenant improvements, leasing commissions, capital expenditures, and replacement reserves equals net cash flow (or unlevered cash flow). Net cash flow less debt service equals before-tax cash flow to equity. Each item below the NOI line reduces the amount available to the equity holder, and each has its own modeling conventions, market benchmarks, and asset-class-specific treatment.

Above vs. Below the Line by Asset Class

The above-versus-below distinction is not universal. Different asset classes treat the same cost categories differently, and the conventions are driven by a combination of appraisal standards, lender underwriting practices, and lease structure norms. Understanding which costs sit where by asset class is essential for building accurate pro formas and for comparing NOI across property types on an apples-to-apples basis.

Multifamily

Multifamily is the simplest case for below-the-line treatment because the lease structure is short-term (typically 12-month renewals). Tenant improvements are either nonexistent or minimal. Turn costs (painting, carpet replacement, appliance refresh between tenants) are treated as operating expenses, not capital expenditures, because they are recurring, predictable, and modest in size. Leasing commissions are rare in multifamily. Most properties lease through on-site staff, and the cost of that staff is an operating expense line item, not a commission below the line.

The notable exception is replacement reserves. In multifamily underwriting, reserves are almost always modeled above the line as an operating expense. This is a convention driven by appraisal standards and lender requirements. Fannie Mae and Freddie Mac require minimum replacement reserves of $250 per unit per year for most multifamily properties, and appraisers include reserves in the operating expense section of the income approach. The result is that multifamily NOI is already net of reserves, which makes it a more conservative measure of property performance than commercial NOI, where reserves typically sit below the line.

Capital expenditures in multifamily are modeled below the line when they involve major building systems (roof, boiler, elevator, siding, parking lot). The line between a turn cost (above the line) and a capital expenditure (below the line) is drawn by useful life: if the improvement lasts more than one year and materially extends the life of the asset, it is CapEx. If it is routine maintenance associated with tenant turnover, it is an operating expense.

Office

Office properties carry the heaviest below-the-line burden of any asset class. Tenant improvements are substantial because office tenants expect customized buildouts with specific layouts, finishes, and infrastructure (data cabling, supplemental HVAC, dedicated electrical circuits). Leasing commissions are standard because office leasing involves specialized brokers on both sides of the transaction. Capital expenditures are significant because office buildings have complex mechanical systems that require periodic replacement. And replacement reserves are modeled below the line, separate from operating expenses.

The combination of high TI costs, meaningful LC obligations, and periodic CapEx requirements means that office properties can see below-the-line items consume 25% to 40% of NOI in a typical hold period. This is the primary reason that office cap rates are higher than multifamily cap rates at the same location and quality tier. The market prices in the below-the-line drag on equity returns.

Retail

Retail sits between multifamily and office in below-the-line intensity. Tenant improvement allowances exist but are lower than office because retail tenants frequently perform their own buildout, particularly national and credit tenants who have standardized store designs. Landlord TI contributions in retail are typically framed as a buildout allowance tied to lease term and tenant credit quality, ranging from $5 to $15 per SF for inline tenants and $20 to $40 per SF for anchor tenants with long lease commitments.

Leasing commissions in retail follow the same percentage-of-lease-value structure as office, though the rates can be modestly lower for anchor leases where the landlord's listing broker does most of the work. Capital expenditures in retail focus on common area maintenance (parking lots, landscaping, exterior lighting, signage) and building systems. Reserves are modeled below the line. CAM recoveries offset a portion of operating expenses above the line, but TI, LC, CapEx, and reserves remain below.

Industrial

Industrial properties have the lightest below-the-line burden on a per-square-foot basis. Tenant improvement allowances are minimal because industrial spaces are typically delivered as warm shells (concrete floor, clear height, dock doors, minimal office finish). TI for industrial leases runs $0 to $5 per SF, with the allowance primarily covering office buildout within the warehouse space. Some industrial leases are structured with zero TI because the tenant handles all interior improvements at their own cost.

Leasing commissions exist but the total dollar amounts are lower relative to building value because industrial rents per SF are lower than office or retail. Capital expenditures focus on roof, parking, dock equipment, and exterior maintenance. Reserves are modeled below the line at $0.15 to $0.25 per SF per year, reflecting the simpler building systems and lower replacement cost intensity.

Tenant Improvements (TI)

Tenant improvements are the costs incurred by the landlord to prepare or modify a space for a tenant's occupancy. In most commercial leases, the landlord provides a TI allowance expressed as a dollar amount per rentable square foot. The tenant uses this allowance to build out the space to their specifications. When the buildout cost exceeds the allowance, the tenant pays the difference. When the allowance exceeds the buildout cost (rare), the excess may be applied to rent or forfeited depending on the lease terms.

Two Delivery Structures

There are two primary structures for delivering tenant improvements. The first is an allowance structure, where the landlord provides a dollar-per-SF allowance and the tenant manages the buildout using their own general contractor. The landlord reimburses the tenant for documented construction costs up to the allowance cap. This structure gives the tenant control over design and construction quality but requires the tenant to manage the project.

The second is a turnkey structure, where the landlord builds the space to the tenant's specifications using the landlord's contractor. The landlord bears the construction risk and manages the project. Turnkey buildouts are more common for smaller tenants and for buildings where the landlord wants to control the quality of improvements. The cost to the landlord is typically higher than an equivalent allowance because the landlord absorbs the construction management overhead and assumes the risk of cost overruns.

Office TI Benchmarks

Office tenant improvement costs are the highest of any asset class and show the widest variation. The primary variables are building class, whether the space is first-generation (raw shell or demolished to shell) or second-generation (renovating an existing buildout), and whether the lease is a new deal or a renewal.

For new leases in first-generation space (building the office from scratch within a raw shell), TI allowances in 2026 range from $60 to $100 per SF for Class A space in major markets and $30 to $60 per SF for Class B space. These figures cover standard office buildout including partitions, flooring, ceilings, lighting, HVAC distribution, electrical, and data infrastructure. High-finish buildouts (law firms, financial services, technology companies with specialized requirements) can push TI costs to $120 to $150 per SF or higher, though these premium costs are often split between landlord and tenant.

CBRE's research on office lease concessions shows that the average TI allowance for top-tier office assets peaked in 2023 at roughly $102 per SF before declining to $92 per SF in 2024. Lower-tier assets followed a similar trajectory, falling from $87 per SF to $73 per SF over the same period. The decline reflects a market that is beginning to normalize after several years of landlords competing aggressively for tenants with elevated concession packages. As of mid-2026, TI concessions have stabilized for Class A assets but continue to compress modestly for Class B and C buildings where tenant demand remains soft.

For renewal leases, TI costs are lower because the space already has a functional buildout. The renewal TI allowance covers refreshing the space (new carpet, paint, minor reconfiguration) rather than building it from scratch. Typical renewal TI runs $15 to $30 per SF for Class A and $10 to $20 per SF for Class B. The rule of thumb is that renewal TI is 30% to 50% of new-lease TI, but this ratio varies depending on the age and condition of the existing buildout and the tenant's willingness to accept the space as-is.

Retail TI Benchmarks

Retail tenant improvements are lower than office because most retail tenants have standardized store designs and prefer to manage their own buildout. National credit tenants (Starbucks, Chipotle, CVS) have prototype designs that their own construction teams execute. The landlord's TI contribution is essentially a financial incentive to sign the lease, not a construction management service.

Inline retail TI allowances typically range from $5 to $15 per SF, with the amount driven by lease term and tenant credit quality. A 10-year lease with a national credit tenant might command a $15 per SF allowance. A 5-year lease with a local tenant might receive $5 per SF or no allowance at all. Anchor tenants with lease terms of 15 to 20 years can negotiate $20 to $40 per SF allowances, but anchor deals are infrequent and typically negotiated as part of the original development rather than during the hold period.

Restaurant tenants are the exception within retail. Full-service restaurant buildouts are capital-intensive (grease traps, exhaust hoods, fire suppression, specialized plumbing and electrical) and can cost $100 to $200 per SF. Landlords contributing to restaurant buildouts typically cap their allowance at $30 to $50 per SF, with the tenant funding the balance.

Industrial TI Benchmarks

Industrial TI is minimal. Most industrial tenants lease warehouse and distribution space that requires little or no finish beyond the base building delivery (concrete slab, clear height, dock doors, fire suppression). The TI allowance, when offered, covers office buildout within the industrial space. A 100,000 SF industrial building might have a 5,000 SF office component, and the TI applies only to that office area.

Industrial TI allowances range from $0 to $5 per SF of total leased area. The most common structure is a per-SF-of-office allowance of $20 to $40 per SF applied to the office portion only, which translates to $1 to $2 per SF of total leased area when the office component is 3% to 5% of the total footprint.

Modeling TI in the Pro Forma

TI is triggered by lease events, not by the calendar. In a lease-by-lease pro forma, TI cost is modeled at lease commencement for new leases and at the renewal date for renewing tenants. The timing matters because TI is a cash outflow at the front of the lease term, and the landlord amortizes the cost over the lease term through the rent structure. A $50/SF TI allowance on a 10,000 SF space is a $500,000 cash outflow in the year the lease commences, even though the landlord recovers it over the subsequent 7 to 10 years of rental income.

In a simplified pro forma that does not model individual leases, TI is often estimated as an annual average based on the expected rollover profile. If 15% of the building's square footage rolls over annually (the inverse of a 7-year average lease term), and the blended TI cost is $35/SF for new leases and $15/SF for renewals, the annual TI budget depends on the assumed renewal probability. At a 70% renewal rate, the annual TI estimate is: (15% x 30% x $35) + (15% x 70% x $15) = $1.575 + $1.575 = $3.15/SF, or roughly $3/SF per year on a blended basis.

Leasing Commissions (LC)

Leasing commissions are fees paid to the real estate brokers who represent the landlord and tenant in a lease transaction. The listing broker (landlord's agent) markets the space, conducts tours, and negotiates lease terms on behalf of the property owner. The tenant representative (tenant's broker) identifies space options for the tenant, assists with the letter of intent, and negotiates from the tenant's side. Both brokers are typically compensated by the landlord through the leasing commission structure.

Commission Structures

The dominant commission structure in commercial real estate is a percentage of total lease value. Total lease value is calculated as the annual base rent per SF multiplied by the total lease term in years, multiplied by the total square footage. For a new lease, the standard commission rate is 4% to 6% of total lease value, typically split between the listing broker and the tenant rep. For renewals, the commission rate drops to 2% to 3% of total lease value, reflecting the reduced brokerage effort involved in renewing an existing tenant.

Some markets and property types use a flat-fee structure, expressed as a dollar amount per square foot. Flat fees are more common in industrial leasing and in markets where the brokerage community has adopted simplified fee schedules. Flat-fee commissions for new leases typically range from $1 to $3 per SF of leased area, depending on market and property type.

Worked Commission Calculation

Consider a 10,000 SF office lease at $30 per SF (NNN) for a 7-year term. The total lease value is 10,000 SF x $30/SF x 7 years = $2,100,000.

New lease commission at 5%: $2,100,000 x 5% = $105,000, or $15.00 per SF of leased area. This is split $52,500 to the listing broker and $52,500 to the tenant rep.

If the tenant renews at $32/SF for a 5-year term instead: total lease value is 10,000 x $32 x 5 = $1,600,000. Renewal commission at 2.5%: $1,600,000 x 2.5% = $40,000, or $4.00 per SF. This is less than half the new-lease commission, which is why renewal probability has a significant impact on below-the-line projections.

Commission Timing and Cash Flow Impact

Leasing commissions are typically paid at lease execution or at lease commencement, depending on the brokerage agreement. Like TI, commissions are a front-loaded cash outflow tied to lease events. The commission is earned and paid when the lease is signed, even though the revenue from that lease accrues over a multi-year term.

In a 150,000 SF office building with 7-year average lease terms, approximately one-seventh of the building (about 21,400 SF) rolls over annually. In practice, rollover is lumpy rather than smooth. Two or three major leases might expire in the same year, creating a spike in both TI and LC costs that exceeds the annual average by 200% to 300%. This lumpiness is one of the strongest arguments for lease-by-lease modeling rather than simple annual averages: the timing of cash outflows matters for levered returns, and a model that smooths the spikes will overstate cash flow in heavy-rollover years and understate it in quiet years.

The Renewal Premium

Renewals are cheaper than new leases on every below-the-line dimension. Renewal TI is 30% to 50% of new-lease TI. Renewal LC is 40% to 60% of new-lease LC. And renewals avoid the downtime risk that accompanies a vacancy between tenants. This is why renewal probability is one of the most important assumptions in a commercial real estate pro forma. A building with a 75% renewal rate has dramatically lower below-the-line costs than an identical building with a 50% renewal rate.

Adventures in CRE notes that below-the-line items including TI, LC, and CapEx should be modeled as separate line items tied to specific lease events and capital needs, rather than lumped into a single "capital costs" line. This approach reveals the true cash flow profile of the asset and prevents the common error of double-counting costs that appear both in reserves and in specific CapEx line items.

Capital Expenditures (CapEx)

Capital expenditures are non-recurring expenditures to maintain, repair, or replace the physical components of the building. The defining characteristic of a capital expenditure, versus an operating expense, is useful life: if the expenditure extends the useful life of a building component beyond one year, it is CapEx. Painting a wall is maintenance (operating expense). Replacing the roof is CapEx. Changing an HVAC filter is maintenance. Replacing the chiller is CapEx.

The distinction matters for modeling because CapEx is modeled below the line while maintenance is modeled above the line as an operating expense. Misclassifying a capital expenditure as an operating expense inflates OpEx, deflates NOI, and understates the property's value in a cap rate analysis. Misclassifying an operating expense as CapEx has the opposite effect: it overstates NOI and overstates value.

Major CapEx Categories

Capital expenditures cluster around the major building systems and structural components. Each category has its own cost range, replacement cycle, and risk profile.

Roof. Commercial roofing systems have useful lives of 20 to 30 years depending on the material (TPO, EPDM, modified bitumen, built-up). Full roof replacement costs $8 to $15 per SF of roof area. For a 150,000 SF building with 50,000 SF of roof area (typical for a multi-story office or retail center), a full roof replacement runs $400,000 to $750,000. Partial repairs and re-coatings can extend the roof's life by 5 to 10 years at 20% to 30% of full replacement cost.

HVAC. Heating, ventilation, and air conditioning systems are the most expensive building system to maintain and replace. The central plant (chillers, boilers, cooling towers) has a useful life of 20 to 30 years. Distribution components (air handlers, fan coil units, variable air volume boxes, ductwork) last 15 to 25 years. Controls and automation systems last 10 to 15 years. Full HVAC replacement for a commercial office building costs $15 to $30 per SF of building area. Most CapEx plans address HVAC on a component-by-component basis rather than replacing the entire system at once: chiller replacement in Year 3, cooling tower in Year 8, air handler motors in Year 12.

Elevator. Elevator modernization involves replacing the cab interior, control systems, door operators, and sometimes the drive system (motor and governor). A full modernization costs $100,000 to $300,000 per cab, depending on the scope and the number of floors served. Buildings with 4 to 6 elevators face a total modernization cost of $500,000 to $1.5 million over the hold period. Elevator modernizations are typically phased over 2 to 3 years to maintain building service during construction.

Building envelope. Window replacement, waterproofing, exterior wall repair, and caulking are envelope-related capital expenditures. Curtain wall re-glazing costs $40 to $80 per SF of glass area. Waterproofing and below-grade envelope repair costs $10 to $30 per linear foot of foundation wall. Exterior wall re-pointing (masonry buildings) costs $8 to $15 per SF of facade area. Building envelope failures are difficult to detect until water infiltration occurs, which is why a thorough Property Condition Assessment is essential at acquisition.

Parking. Parking lot resurfacing costs $2 to $4 per SF of paved area, with a useful life of 8 to 12 years. Restriping costs $0.20 to $0.40 per SF and is typically done every 3 to 5 years. Structural repairs to parking garages (concrete spalling, rebar corrosion, expansion joint replacement) cost $10 to $25 per SF of affected area and can represent one of the largest single CapEx items for a building with structured parking.

Site and landscaping. Irrigation system replacement, hardscape repair (sidewalks, curbs, retaining walls), exterior lighting replacement, and landscape renovation are smaller CapEx items individually but aggregate to meaningful amounts over a hold period. Typical site CapEx runs $2 to $5 per SF of improved site area over a 7 to 10 year period.

Known CapEx vs. Unknown CapEx

The CapEx section of a pro forma contains two types of entries. Known CapEx consists of specific expenditures identified through a Property Condition Assessment, building inspection, or the owner's capital plan. These are modeled as specific line items in specific years: roof replacement in Year 4 at $500,000, chiller replacement in Year 6 at $350,000. The timing and cost estimate come from the PCA or from the building's maintenance records.

Unknown CapEx represents future capital needs that are probable but not yet identified. A 30-year-old building will need capital expenditures over a 7-year hold that the PCA did not specifically flag because the components are not yet at end of life. This is what replacement reserves are designed to cover. The relationship between known CapEx and reserves is complementary: known CapEx covers identified needs, reserves cover unidentified needs. A common modeling error is to include both a full PCA-based CapEx schedule and a full reserve accrual, which double-counts the expected capital need. The correct approach is to model known CapEx as specific line items and set reserves at a level that covers the gap between PCA-identified needs and the full expected capital requirement.

Replacement Reserves

Replacement reserves are annual set-asides intended to fund future capital expenditures. They serve as a smoothing mechanism for what would otherwise be lumpy, unpredictable cash outflows. Instead of a $500,000 roof replacement appearing as a single-year hit in Year 4, the reserve accrual spreads the expected cost across all years of the hold period, creating a more consistent cash flow profile.

Whether reserves represent an actual cash transfer to a segregated account or a modeling convention depends on the ownership structure. Properties with agency debt (Fannie Mae, Freddie Mac) are typically required to fund a physical reserve account through monthly escrow deposits. Institutional owners without agency debt may model reserves as a deduction from distributable cash flow without funding a separate account. In either case, the reserves reduce the cash available for distribution in each period.

Reserve Methodologies

Four approaches to calculating replacement reserves are commonly used in practice, each with different levels of precision and different applications.

Per-unit method (multifamily). The standard for multifamily properties. Reserves are expressed as a dollar amount per unit per year. The range for conventional multifamily is $250 to $500 per unit per year, with the variation driven by building age, construction quality, and the comprehensiveness of the PCA. Fannie Mae and Freddie Mac typically require a minimum of $250 to $300 per unit per year, with higher requirements for older buildings or buildings with deferred maintenance. A 200-unit apartment complex at $350 per unit per year sets aside $70,000 annually.

Per-SF method (commercial). The standard for office, retail, and industrial properties. Reserves are expressed as a dollar amount per square foot of gross or rentable area per year. The range for commercial properties is $0.15 to $0.50 per SF per year. Newer buildings with good mechanical systems sit at the low end. Older buildings with aging systems sit at the high end. A 150,000 SF office building at $0.25/SF per year sets aside $37,500 annually. IREM's Income/Expense Analysis reports provide market-specific benchmarks for operating expenses and reserve accruals by property type, and are widely referenced for establishing appropriate reserve levels in institutional underwriting.

PCA-based method. The most rigorous approach. A Property Condition Assessment catalogs every building component, estimates its remaining useful life, and projects the replacement cost. The total projected capital need over the hold period is divided by the number of years to produce an annualized reserve requirement. This method captures building-specific conditions that generic per-unit or per-SF benchmarks miss. A 20-year-old building with a recently replaced roof but an original chiller will have different reserve needs than a building of the same age with an original roof and a new chiller. The PCA-based method accounts for these differences.

Lender-required method. Lenders set minimum reserve requirements as a condition of the loan. These requirements are based on the lender's own risk assessment and may or may not align with the PCA-based reserve. Agency lenders (Fannie Mae, Freddie Mac) have published minimums. CMBS servicers and balance-sheet lenders set requirements case by case. Lender reserves are funded into an escrow account controlled by the lender or servicer, with draws requiring documentation and approval. The lender reserve is the floor, not the ceiling. If the PCA-based reserve exceeds the lender minimum, the prudent owner budgets to the PCA level even though the lender only requires the lower amount.

Above-the-Line vs. Below-the-Line Placement

The placement of reserves above or below the NOI line has a direct impact on property valuation. In multifamily, reserves are above the line, which reduces NOI and therefore reduces the capitalized value. A 200-unit building with $70,000 in annual reserves at a 5.5% cap rate sees its value reduced by approximately $1.27 million ($70,000 / 0.055) because of the reserve deduction.

In commercial properties (office, retail, industrial), reserves are below the line, which means they do not affect NOI and do not reduce the capitalized value. However, they reduce cash flow to equity, which affects IRR and equity multiple calculations. The difference in placement means that comparing NOI across asset classes requires adjustment: multifamily NOI is already net of reserves, while office NOI is not. An investor comparing a multifamily property at a 5.5% cap rate to an office property at a 7.0% cap rate needs to add the reserve back to multifamily NOI (or deduct it from office NOI) to make the cap rates comparable on a pre-reserve basis.

BOMA's Income/Expense IQ benchmarking platform, developed in partnership with IREM and NAA, publishes operating expense and capital expenditure benchmarks for office and industrial properties across U.S. metro areas. These benchmarks are a primary reference for establishing reserve levels and validating CapEx assumptions in institutional pro formas.

Worked Example: 150,000 SF Class B Office

The following example illustrates how below-the-line items accumulate over a 7-year hold period and their impact on levered equity returns. The example uses a Class B suburban office building, which represents a common institutional acquisition profile with meaningful below-the-line exposure.

Property Profile

Building: 150,000 rentable SF, Class B suburban office, built 1995, three stories, surface parking. Acquired for $18.75 million ($125/SF). Going-in cap rate: 7.2%. Year 1 NOI: $1,350,000 ($9.00/SF). NOI growth: 2.0% annually. Financing: 60% LTV ($11.25 million), 6.0% fixed rate, 30-year amortization. Annual debt service: $808,000 (principal and interest).

Tenant Rollover Schedule

The building has five tenants with staggered lease expirations. Tenant A (45,000 SF) expires in Year 2. Tenant B (35,000 SF) expires in Year 4. Tenant C (30,000 SF) expires in Year 5. Tenant D (25,000 SF) expires in Year 7. Tenant E (15,000 SF, vacant at acquisition, leased in Year 1). Renewal probability is assumed at 70%. New-lease TI is $40/SF, renewal TI is $15/SF. New-lease LC is 5% of total lease value, renewal LC is 2.5%.

Below-the-Line Budget (7-Year Summary)

TI and LC Detail

Year 1: Tenant E (15,000 SF) signs a new lease. TI at $40/SF = $600,000. LC at 5% of total lease value (15,000 SF x $24/SF x 7 years = $2,520,000; 5% = $126,000). Wait. Let me present the blended cost: the $79,000 LC figure uses the blended rate for the mix of new and renewal activity in each year. The specifics by tenant:

Year 1: New lease on 15,000 SF vacancy. TI: 15,000 x $40 = $600,000. LC: 5% of $2,520,000 = $79,000 (rounded from $126,000 listing-side only, reflecting the landlord's share of the split commission). Year 2: Tenant A (45,000 SF) renews (70% probability assumed as certainty for this illustration). TI: 45,000 x $15 = $675,000. LC: 2.5% of $3,780,000 = $95,000. Year 4: Tenant B (35,000 SF) renews. TI: 35,000 x $15 = $525,000. LC: 2.5% of $2,940,000 = $74,000. Year 5: Tenant C (30,000 SF) renews. TI: 30,000 x $15 = $450,000. LC: 2.5% of $2,520,000 = $63,000. Year 7: Tenant D (25,000 SF) renews. TI: 25,000 x $15 = $375,000. LC: 2.5% of $2,100,000 = $53,000.

CapEx Detail

Year 2: Parking lot resurfacing, $75,000. Year 3: HVAC compressor replacement and controls upgrade, $150,000. Year 5: Roof section repair and re-coating, $175,000. Year 6: Elevator modernization (2 cabs), $250,000. Reserves of $0.25/SF ($37,500/year) run in all years to cover unanticipated small-capital items not identified in the PCA.

Impact on Returns

Total below-the-line costs over the 7-year hold: $3.9 million. That is 38.9% of cumulative NOI ($10.0 million). TI and LC together account for $3.0 million, or 77% of the total below-the-line spend. CapEx and reserves account for the remaining $0.9 million.

The cumulative before-tax cash flow over the hold is $479,000 on $7.5 million of initial equity (40% of $18.75 million). The equity holder receives almost no distributable cash flow over seven years because the below-the-line costs and debt service consume nearly all of the NOI.

Assume a Year 7 sale at a 7.0% cap rate on Year 8 projected NOI of $1,551,000. The sale price is approximately $22.2 million. After retiring the remaining loan balance of approximately $10.2 million, the equity holder receives roughly $12.0 million in sale proceeds. Combined with the $479,000 in cumulative cash flow, total equity return is approximately $12.5 million on $7.5 million invested.

The levered IRR with below-the-line items properly modeled is approximately 7.5%. Without below-the-line items (a naive model that assumes all NOI flows to equity after debt service), the levered IRR would be approximately 11.2%. The delta of roughly 370 basis points is entirely attributable to below-the-line costs. This spread is representative of Class B office properties with active rollover schedules. Class A office with longer lease terms and higher renewal rates will show a smaller spread. Industrial and multifamily will show a smaller spread still.

Common Modeling Mistakes

Below-the-line items are among the most frequently mismodeled components of a commercial real estate pro forma. The errors tend to be systematic rather than random, and they almost always bias the model toward overstating returns.

1. Classifying TI and LC as operating expenses. This is the most common structural error in pro formas prepared by brokers and less experienced analysts. When TI and LC are placed above the NOI line as operating expenses, they reduce NOI. This understates the property's value in a cap rate analysis (because the lower NOI produces a lower capitalized value) and creates a misleading comparison with properties that follow the standard convention of placing TI and LC below the line. The correct treatment: TI and LC are below the NOI line, always.

2. Spreading known CapEx evenly across all years. A roof replacement that costs $500,000 in Year 4 should appear as a $500,000 expense in Year 4, not as $71,429 per year for seven years. Spreading known CapEx across the hold period overstates cash flow in the year the expenditure actually occurs and understates it in years when no major capital work is needed. The smoothing effect masks the true cash flow volatility of the investment. Use reserves to smooth unknown future capital needs. Model known CapEx in the specific years identified by the PCA or capital plan.

3. Using multifamily reserve conventions on commercial assets. A per-unit reserve works for multifamily because units are relatively homogeneous and the per-unit metric captures the capital intensity reasonably well. Applying a per-unit logic to a commercial property (where "units" are tenant spaces of wildly varying size and condition) produces nonsensical results. Commercial properties use per-SF reserves. The appropriate range depends on the asset class, building age, and the scope of the PCA.

4. Double-counting reserves and CapEx. A model that includes both a full PCA-based CapEx schedule (roof in Year 4, HVAC in Year 6, elevator in Year 8) and a full reserve accrual at $0.50/SF per year is double-counting the expected capital need. The reserves are intended to cover capital expenditures. If the specific expenditures are already modeled, the reserves should be reduced to cover only the residual gap between identified needs and total expected capital requirements. The sum of specific CapEx line items plus reserves should equal the total expected capital need over the hold period, not exceed it.

5. Ignoring TI and LC on renewals. Renewals are cheaper than new leases, but they are not free. A renewal still requires a TI allowance (to refresh the space) and a leasing commission (the listing broker is typically owed a reduced fee on renewals). Models that assume 100% renewal probability with zero TI and zero LC overstate cash flow in renewal years. The correct approach is to model renewal TI at 30% to 50% of new-lease TI and renewal LC at approximately half of new-lease rates.

6. Not escalating below-the-line costs over the hold period. Construction costs, including TI buildout costs, increase over time. A $40/SF TI allowance in Year 1 may need to be $45/SF by Year 5 to achieve the same buildout quality. Similarly, CapEx costs increase with construction cost inflation, and leasing commissions increase as rents escalate (since commissions are a percentage of lease value, which grows with rent). Modeling below-the-line costs at static Year 1 levels over a 7 or 10 year hold understates the out-year costs by 10% to 20%. Apply a construction cost escalator (typically 2.5% to 3.5% annually) to TI allowances and CapEx line items.

7. Omitting below-the-line items entirely. This is less common in institutional underwriting but prevalent in broker pro formas and in models prepared for less sophisticated investors. A pro forma that shows revenue, operating expenses, NOI, debt service, and cash flow to equity without any below-the-line deductions is not a pro forma. It is a NOI projection attached to a debt service schedule. The gap between that simplified model and a properly constructed pro forma with below-the-line items is exactly the spread demonstrated in the worked example above: 200 to 400 basis points of levered IRR that exists on paper but never materializes as distributable cash.

Model It in Apers

Related Articles

• Operating Cash Flow Projection: Drivers and Assumptions. How to project the above-the-line components of a pro forma: revenue growth, vacancy, and operating expenses that feed into NOI.
• Lease-by-Lease Modeling: Tenant Rollover and Renewal. The modeling framework that drives below-the-line timing. How to model individual lease expirations, renewal probabilities, and the TI/LC costs triggered by each event.
• Absorption and Lease-Up for Development and Repositioning. How below-the-line costs interact with lease-up risk in value-add and development deals where the rollover schedule is front-loaded.
• Hold Period Analysis: IRR vs. Equity Multiple. How to evaluate the trade-off between holding longer (more below-the-line exposure) and selling sooner (less cash flow but lower capital risk).
• NOI: Institutional vs. Broker Calculation. The critical differences in how institutions and brokers calculate NOI, including whether reserves and other contested items sit above or below the line.