Return Risk and Cash Flow Risk with Long‐term Riskless Leases in Commercial Real Estate

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Abstract
This paper presents a conceptual analysis of some of the key fundamentals that underlie the risk characteristics of commercial real estate returns. In particular, the relationship between the property's return risk and its cash flow risk is explored. This relationship is important because it is the return risk that should matter most to investors, yet it is the cash flow risk or market risk about which we may have the most objective information and the most intuition. This is because real estate assets are generally unsecuritized and trade too infrequently to observe time series of returns (including appreciation) that could be used to directly study the risk characteristics of the returns. By explicitly incorporating the possibility of cash flows governed by riskless long‐term leases, this paper also explores the relationship between lease term and both cash flow risk and return risk.