Capital Expenditures (CapEx)

How capital expenditures work

Every building spends money in two different ways. The first is the cost of operating it from month to month: taxes, insurance, utilities, management, and the repairs that keep things working. Those are operating expenses, and subtracting them from income gives net operating income. The second is spending that replaces or improves a major component, such as a roof, a boiler, an elevator, a parking surface or a lobby. That is capital spending, and it does not appear in NOI at all.

Cash flow after capital = NOI − CapEx − Debt service

This is why NOI can flatter a property. An owner can show a healthy NOI in a year when nothing big was replaced, and a very different cash picture in the year the roof fails. CapEx is lumpy by nature; NOI is smooth by definition. Lenders, appraisers and buyers all try to put the two on the same footing, and the tool they use is the replacement reserve: a level annual charge that stands in for the lumpy spending.

Typical capital items

• Building envelope: roof replacement, facade and window work, waterproofing.
• Mechanical systems: HVAC replacement, boilers, plumbing risers, electrical service upgrades.
• Site: repaving and restriping, drainage, lighting, signage.
• Interiors and common areas: lobby and corridor renovation, unit renovations in an apartment building, new elevators.
• Leasing costs: tenant improvements and leasing commissions on office, retail and industrial space. Some reports show these separately from building CapEx.
• Expansion: additions and new buildings, which are usually financed separately from the existing mortgage.

Three kinds of CapEx

Investors tend to sort capital spending into three groups, and lenders treat each differently:

• Maintenance (or replacement) CapEx keeps the property performing as it does now. It is the part that replacement reserves are meant to cover.
• Deferred or immediate CapEx is what the previous owner should have done. It shows up in the property condition report, and lenders often require it to be completed after closing, sometimes funded in escrow.
• Value-add (or growth) CapEx is spending to raise income: renovating units, repositioning a building, adding amenities. It is the budget behind a value-add business plan, and it is usually financed by a bridge or renovation loan rather than paid from NOI.

CapEx or repair? How the IRS draws the line

The same invoice can be a deduction or a depreciable asset, so the distinction matters for taxes as well as for underwriting. The IRS rules on this are in Treasury Regulation 1.263(a)-3, which says that amounts paid to improve a unit of property must generally be capitalized. An amount improves the property if it is a betterment (it fixes a material defect or adds to or enlarges the property), a restoration (it replaces a major component or restores the property after it has deteriorated), or an adaptation (it converts the property to a new or different use). Work that does none of these is generally an ordinary repair that can be deducted.

In practice, patching a roof leak is a repair; stripping and replacing the roof is capital. Fixing a broken compressor is a repair; replacing the rooftop system is capital. Repainting a hallway is a repair; gutting and rebuilding the lobby is capital. Where a job falls in between, the answer depends on the facts, and your tax adviser should make the call.

Safe harbors that simplify small spending

• De minimis safe harbor. Under Treasury Regulation 1.263(a)-1(f), you can elect to deduct items up to $2,500 per invoice or item, or $5,000 if you have an applicable financial statement and treat the amounts as expenses there. Written accounting procedures treating such amounts as expenses must also be in place. The election is made each year by attaching a statement to a timely filed original return.
• Small taxpayer safe harbor for buildings. Under Treasury Regulation 1.263(a)-3(h), a business with average annual gross receipts of $10 million or less can elect to deduct repairs, maintenance and improvements to a building with an unadjusted basis of $1 million or less, provided the year’s total for that building does not exceed the lesser of 2% of its basis or $10,000. For a building with a $750,000 basis, the regulation’s own example caps the total at $10,000, because 2% of the basis would be $15,000. Going over the cap disqualifies the building for that year.

These safe harbors are for small buildings and small spending. A roof or HVAC replacement on a typical commercial property will exceed them.

How CapEx is depreciated

Capitalized costs are recovered through depreciation. IRS Publication 946 gives the general recovery period for residential rental property as 27.5 years and for nonresidential real property as 39 years. Interior improvements to a nonresidential building made after the building was first placed in service are qualified improvement property under section 168(e)(6) of the Internal Revenue Code, which carries a 15-year recovery period. By statute that category excludes work that enlarges the building, elevators and escalators, and the building’s internal structural framework. Because QIP covers only interior portions of a building, exterior work generally falls outside it.

Property with a recovery period of 20 years or less can qualify for the additional first-year (bonus) depreciation allowance. The One Big Beautiful Bill Act made the 100% rate permanent for qualified property acquired after January 19, 2025, and the IRS has said property acquired before January 20, 2025 stays under the earlier phase-down even if it is placed in service later. A taxpayer can elect a lower percentage for the first year. Whether a given improvement qualifies, and whether taking the deduction is wise given a future sale, is a question for a tax professional. Our depreciation calculator shows the straight-line effect of a recovery period.

Worked example: a 40,000 sq ft retail center

An investor is buying a 40,000-square-foot retail center. The seller’s operating statement shows $312,000 of NOI before any reserve. The lender underwrites a replacement reserve of $0.25 per square foot, or $10,000 a year, bringing underwritten NOI to $302,000. The property condition report, however, shows work coming up over the next five years: a roof replacement ($240,000), repaving ($80,000) and HVAC replacement ($60,000), totalling $380,000, or $76,000 a year on average. All figures are illustrative assumptions.

Measure	Lender’s reserve ($10,000/yr)	Capital plan ($76,000/yr)
NOI before reserve	$312,000	$312,000
Capital charge	−$10,000	−$76,000
NOI after capital charge	$302,000	$236,000
Value at a 7.0% cap rate	$4,314,286	$3,371,429
Maximum loan at a 9.0% debt yield	$3,355,556	$2,622,222
Coverage on $250,000 of annual debt service	1.21x	0.94x

The 7.0% cap rate, 9.0% debt yield floor and $250,000 debt service are illustrative inputs, and the arithmetic follows the same formulas as our cap rate and debt yield calculators.

Read the table in two ways. First, the lender’s underwriting is not wrong: a $0.25 allowance is a standard-looking placeholder, and it produces a loan that works on paper. But the property will need $380,000 of real money in five years, and the average year after capital spending would not cover a $250,000 debt payment (see DSCR): $236,000 ÷ $250,000 is 0.94x. The $14,000 shortfall comes out of the owner’s pocket, and the roof year would be far worse.

Second, the capital plan is exactly what a careful lender or appraiser will pick up from the property condition report. Where the report calls for much more than the standard reserve, expect the lender to raise the reserve, require repairs up front, or lower the loan. At the extreme in this example, reserving the full $76,000 would take roughly $733,000 off the maximum loan and about $943,000 off the value.

What the buyer can do with the number

• Price it. A known $380,000 roof, paving and HVAC bill is a reason to negotiate the price, ask for a credit at closing, or have the seller complete the work.
• Schedule it. A roof does not fail on a convenient date. Spreading replacements over five years with a funded reserve is cheaper than an emergency.
• Finance it. If the work is part of a repositioning plan, a bridge loan or a renovation or construction loan can fund it, and a permanent loan can take out the result once it is stabilized.

CapEx vs. similar terms

• Operating expense (OpEx) recurs and is inside NOI; CapEx is outside it. See operating expense ratio.
• Replacement reserve is the forecast, a level annual allowance; CapEx is the cash actually spent when something is replaced. See replacement reserves.
• Repairs and maintenance keep a component working; CapEx replaces or improves it. Repairs are a deductible operating cost, subject to the IRS tests above.
• Tenant improvements and leasing commissions are capital costs of re-leasing space, reserved separately from building components. See TI/LC reserves.
• Depreciation is the accounting write-off of past capital spending; CapEx is the cash going out. Depreciation does not set aside a dollar for the next roof.

Why lenders care

A lender is repaid from NOI, but it takes the loss if the building deteriorates. CapEx therefore reaches a loan in four ways:

• In the sizing. Many lenders subtract a replacement reserve before applying debt yield and coverage tests, so more capital need means less loan.
• In an escrow. Many loans collect the reserve monthly into an account the lender controls. Cash is released against approved work, and the balance is a use of your cash flow.
• In required repairs. A property condition assessment sorts needed work by urgency. Fannie Mae’s PCA instructions describe critical repairs as items that should typically be addressed immediately or within six months, and deferred maintenance as typically within twelve months. Its Multifamily Guide says the repair escrow funded at origination should be at least 125% of the estimated cost, though a lender may choose not to fund it if the borrower has the financial capacity to complete the repairs, and completion should be confirmed no later than 12 months after origination. Other lenders set their own terms.
• In the business plan. For a bridge or value-add loan, the capital budget is part of the loan request. Lenders may fund part of it in draws or holdbacks against completed work, and they look at whether the plan produces enough income to refinance.

Underwriters also look for CapEx hiding in the numbers. A trailing twelve months statement with no capital spending on an older building suggests deferred work. Capital items booked as repairs inflate expenses and understate NOI; repairs booked as capital inflate NOI. A pro forma that assumes big rent growth with no renovation budget invites the same question.

What to watch for

• Read the property condition report before the lender does. If you commission it during due diligence, you can price the findings into the deal instead of absorbing them in the loan.
• Know which reserve you are quoted. Ask whether NOI is before or after the reserve, who holds the reserve cash, and how releases work.
• Ask about reserve increases. Some loan documents let the servicer raise the reserve after a later inspection. Read that section before you sign.
• Do not defer work to flatter a sale. Skipped maintenance gets discovered in diligence and typically costs more than doing it.
• Classify costs consistently. Keep invoices that show what was replaced and why, so repairs and improvements can be supported on your tax return and in lender reporting.
• Match the financing to the spending. Do not fund a $400,000 roof from an operating line that has to be repaid from NOI.

What it means for you

Before you apply, list the building’s major components, estimate when each will need replacing, and divide the total by the years until then. If the number is far above what the lender will reserve, you have found the gap in your cash flow before anyone else did. For the loan effect of any NOI change, use the NOI calculator and the debt yield calculator, and read how lenders use NOI. If the work is part of a renovation or repositioning plan, see our guide to tenant improvement financing, and when you are ready, send us the property details and we will look at how the capital plan fits the loan.

Sources: 26 CFR §1.263(a)-1(f) (de minimis safe harbor) and §1.263(a)-3 (betterments, restorations, adaptations; small taxpayer safe harbor, paragraph (h)); IRS, Tangible property final regulations; IRS Publication 946 (2025), How to Depreciate Property; 26 U.S.C. §168(e)(6) (qualified improvement property); IRS news release on Notice 2026-11 (additional first-year depreciation under the One Big Beautiful Bill Act); Fannie Mae Multifamily Selling and Servicing Guide (Completion/Repairs) and Form 4099, PCA instructions. Example figures are illustrative.