Introduction
The headline rent on a commercial lease is a starting point, not the actual landlord economics. Tenant improvement (TI) allowances, leasing commissions (LCs), free rent, and CAM reconciliations all reshape the cash flow the landlord actually receives, and on most modern office leases the effective rent runs 15 to 30% below the headline base rent once these items are netted out. The size of the gap depends on the lease structure: NNN leases push CAM and operating-expense risk onto the tenant but typically come with similar TI packages, while full-service gross leases keep all expense risk with the landlord on top of the same concession menu. Understanding the mechanics matters for valuation (effective rent is what NOI is built from), for underwriting (lease-roll DCFs need defensible TI, LC, and free-rent assumptions at each renewal), and for pitching (a sponsor or REIT client expects the analyst to know what a Class A office lease costs to execute, not just what the press-release rent number says).
The 2020-2024 office market made the mechanics visible. Headline base rents in most CBD markets declined only modestly through the work-from-home transition, but concession packages (free rent, TI allowances) expanded materially. JLL reported the national average office TI allowance at roughly $75 per square foot in 2024, down 6% year-over-year, while CBRE reported $87.51 per square foot in 2024 versus $97.55 in 2023. Both numbers are still elevated relative to historical norms, and regional variation is wide: San Jose led all US markets at roughly $226 per square foot, with Orange County and Los Angeles near $160 per square foot. Headline rent comparisons that ignore these concessions miss most of the actual economic story.
Tenant Improvement Allowances
A tenant improvement (TI) allowance is the dollar amount the landlord agrees to fund toward the tenant's space build-out. The allowance pays for partition construction, flooring, ceiling work, electrical and HVAC modifications, finishes, and any other build-out costs the tenant requires to occupy the space. The structure varies: the landlord may pay the GC directly, reimburse the tenant against contractor invoices, or front the full amount as a lump sum at lease commencement.
| Property Type | Typical TI Range (Per SF, US Class A) |
|---|---|
| Office (new lease) | $50-$150, regionally up to $200+ in top tech markets |
| Office (renewal) | $15-$40 (refresh-only) |
| Industrial / warehouse | $5-$25 |
| Retail (in-line, new lease) | $30-$80 |
| Life sciences / lab build-out | $200-$500+ |
| Medical office | $60-$120 |
- Tenant Improvement (TI) Allowance
The landlord-funded build-out budget on a commercial lease, expressed in dollars per square foot. Covers partition construction, flooring, electrical and HVAC modifications, finishes, and other improvements the tenant requires to occupy the space. The allowance is structured either as a direct payment to contractors, reimbursement against invoices, or a lump-sum advance. The TI cost is a below-the-line capex item for the landlord, reducing NCF but not NOI, and amortized economically over the lease term.
The TI amount is calibrated against the lease term and the tenant's credit. Lease term matters: a 10-year lease justifies roughly double the TI of a 5-year lease, because the landlord can amortize the cost over more years of rent. Tenant credit matters: an investment-grade tenant on a long-duration lease can extract a higher TI package than a non-IG tenant in the same space. Market conditions matter: soft markets increase the TI package as landlords compete for tenants without dropping base rent (preserving the building's rent comps for valuation purposes).
TI Amortization
Underwriters typically amortize the TI cost over the lease term to estimate the true effective rent. The mechanic is the difference between cash NOI and GAAP NOI: the landlord funds the full TI upfront in cash, but GAAP and underwriting both spread that capital over the years it supports. The simple straight-line version is annual TI amortization = total TI / lease term in years, and the cost-of-capital version annualizes the upfront dollars at the required return so the rent-equivalent reflects the time value of the cash outlay. A $75/SF TI on a 10-year lease at a 7% cost of capital amortizes to roughly $10.68 per SF per year of effective rent reduction (versus $7.50 per SF per year on a pure straight-line basis). If the headline rent is $50/SF, the effective rent net of TI is closer to $39.30/SF. The same logic applies to leasing commissions: the upfront LC dollars are amortized over the lease term so the per-year drag can be netted against face rent. The amortization framework converts the upfront capex into an annualized rent-equivalent that can be compared cleanly across leases with different TI structures and terms.
Leasing Commissions
Leasing commissions (LCs) are brokerage fees paid to procure or renew tenants. The market convention is roughly 4-6% of total lease value on new leases and 2-3% on renewals, paid to the tenant rep broker (if any) and the landlord rep broker (typically split). Larger leases may negotiate slightly tighter rates; smaller leases sometimes pay higher percentage rates. On a 10-year, 50,000 SF office lease at $50/SF, the total lease value is $25 million and a 5% new-lease commission equals $1.25 million paid to brokers at lease execution.
LCs are a transaction-event expense rather than a recurring expense, which is why they are typically modeled as below-the-line items in the NCF waterfall rather than as part of operating expenses inside NOI. The accounting treatment varies: some landlords amortize LCs over the lease term for GAAP purposes; institutional underwriting typically captures the LC as an upfront capex event at the lease commencement date.
Free Rent and Effective Rent
Free rent is rent abatement during early lease months, typically 3 to 18 months on new leases (longer in soft markets or for early-lease-up periods on new developments). The mechanic is straightforward: the tenant pays no base rent during the free-rent period and starts paying full rent at the end of the abatement. The landlord absorbs the lost rent as a concession.
The combined effect of TI, LC, and free rent on effective rent is significant. Most modern Class A office leases in major US markets carry effective rents of roughly 70-85% of the headline base rent. The lower end (70%) reflects soft markets with large concession packages; the higher end (85%) reflects tight markets with light concessions. Quoted face rents that ignore the effective-rent adjustment are systematically misleading, which is why institutional underwriting and brokerage comp data increasingly report both face rent and net effective rent for each comp. The concession environment is most pronounced in office, where office lease economics now hinge on TI and free-rent packages rather than headline rent movement.
CAM Recoveries and Reconciliation
Common Area Maintenance (CAM) recoveries are the year-end true-up between estimated and actual operating-expense pass-throughs in NNN and modified-gross leases. The mechanic runs on a 12-month cycle:
- 1.At the start of each lease year, the landlord prepares a budget estimate for property taxes, insurance, CAM, and (in some structures) other operating expenses.
- 2.The tenant pays monthly installments alongside base rent based on the budget estimate (typically 1/12 of the annual estimate each month).
- 3.After the calendar or fiscal year ends, the landlord compiles actual expense data (typically within 90 to 120 days after year-end).
- 4.The landlord issues a reconciliation statement comparing the estimated and actual amounts.
- 5.If actual costs exceeded the estimate, the tenant pays the difference. If the estimate was too high, the tenant receives a refund or a credit toward future payments.
- CAM Reconciliation
The year-end accounting process that compares a landlord's estimated CAM and operating-expense recoveries collected from tenants during the prior 12 months against the actual expenses incurred. The reconciliation produces either a true-up bill to the tenant (if actuals exceeded estimates) or a refund or credit (if estimates exceeded actuals). CAM reconciliation typically completes within 90 to 120 days after the lease year ends; lease agreements specify the timing, the documentation tenants are entitled to review, and the dispute process.
How much of the operating-expense load actually flows back from tenants is captured by the expense recovery ratio, the share of total OpEx recovered through pass-throughs. A landlord with a fully recovering NNN rent roll runs a ratio near 100%; a full-service gross building, where the landlord absorbs expenses, runs much lower. The ratio is the single number an underwriter uses to size the landlord's true net expense burden across a mixed lease roll:
In the retail context the recovered numerator is principally CAM recoveries (plus tax and insurance pass-throughs), so the same ratio is often quoted as the CAM recovery ratio, and it is what the year-end reconciliation above ultimately trues up to. A building modeled at a 95% recovery ratio that reconciles to 80% has a leakage problem the acquisition NCF never priced in.
Caps, Gross-Ups, and Disputes
Several CAM mechanics create regular tenant-landlord disputes worth knowing:
- CAM caps limit the annual increase in recoverable CAM that the tenant must pay (typically 3-5% per year cumulatively, sometimes 4-7% per year on an annual basis). A cap protects the tenant from expense spikes; a landlord stuck below a cap may absorb true expense growth.
- Gross-ups allow the landlord to allocate expenses as if the building were 95-100% occupied, even when actual occupancy is lower. The adjustment restates only the variable, occupancy-driven portion of OpEx (utilities, cleaning, some management) to the gross-up basis: grossed-up variable OpEx = actual variable OpEx multiplied by (gross-up occupancy / actual occupancy), while fixed costs like property tax and insurance pass through unchanged. The mechanic prevents under-occupied buildings from passing through artificially low expense levels (which would re-rate downward when occupancy normalizes).
- Pass-through definitions of what constitutes a recoverable expense vary by lease. Modern leases typically exclude landlord's mortgage interest, depreciation, marketing costs, and capital improvements with useful lives beyond the lease term, but the exact exclusions are negotiated lease-by-lease. Retail leases add their own wrinkles on top of CAM, where percentage rent and pro-rata CAM mechanics layer sales-based rent onto the same recovery framework.
Treating TI, LC, free rent, and CAM as a single concession package is what an experienced underwriter actually does. Each piece is negotiated separately but they reach the landlord's NCF together, and shifting the mix (more TI in exchange for less free rent; tighter CAM caps in exchange for a longer lease) is the standard horse-trading at lease execution. The package as a whole is what determines whether the lease the deal team just signed actually supports the underwriting case the model assumed when the building was acquired.
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