Exhibit 1-1 presents a visual overview of this system, including the major elements in and linkages among these three major components.

The exhibit also shows how this system is linked to other, exogenous systems, including the national and local macro-economies and the national and international capital markets.

Let's briefly walk through the real estate system depicted in Exhibit 1-1.

The three large boxes in the exhibit represent the three main elements of the real estate system: the space market, the asset market and the development industry.

Within the space market, we see the interaction of usage demand with the current stock of physical space supply, which determines current rents and occupancy levels in the space market.

Underlying the demand side of the space market are the national and local economies, which determine the need for certain quantities of physical space of various types as a function of the cost for such space.

Governing the amount of physical space on the supply side are the past and current activities of the development industry.

Moving down to the asset market, we see that the space market determines the current operating cash flows produced by the real estate assets.

This operating cash flow interacts with the cap rates required by investors to determine current property market values in the asset market.

Both the supply and demand sides of the real estate asset market consist of investors, who are currently on the buy side and the sell side.

All of these real estate investors are operating within the broader capital markets, which contain other forms of assets and money markets.

Investors' desires and perceptions about the investment risks and returns of real estate assets determine the current market cap rates required by investors.

A key determinant of cap rates is also investors' forecasts about the future supply and demand in the relevant market segments.

Thus, we see how the space and asset markets, reflecting the underlying economic base and capital market forces, interact to determine current real estate asset market values.

These values represent the key signal, or output, from the asset market: input into the development industry, the third major component of the system.

Within the development-industry component of the system, a crucial comparison is made.

Current development costs, including construction and land costs incorporating necessary profit for the developer, are compared against current asset values.

If asset values equal or exceed development costs, then development will proceed, thereby adding to the physical stock on the supply side of the space market.

A key component of development costs is the opportunity value of the land, including all of the land acquisition costs.

This opportunity value is determined in the real estate asset market, as land is a type of real estate asset.

Of course, development takes time, and this requires that the development industry be somewhat forward-looking.

The developer succeeds only if the newly completed built property's value exceeds its total development costs at the time of completion, which may be several years away.

Not only must developers be forward looking to account for construction time, but the space market is also forward-looking.

But the greatest incentives for peering into the long-run future probably reside in the asset market component of the system.

Asset market participants are inherently forward-looking.

Investors make or lose money depending on how their investments do subsequent to their purchase.

Even when an investor sells relatively quickly to another investor, the price the second investor is willing to pay depends on her views of the future.

To forecast future income streams from real estate assets, investors must forecast the local economic fundamentals underlying space market demand.

They must also attempt to forecast capital-market and national macroeconomic factors, such as interest rates, inflation, and investor preferences.

It is important to note that within the real estate system depicted in Exhibit 1-1 there exist what are called negative feedback loops.

These are dampening mechanisms that tend to make a system self-regulating, preventing it from spiraling out of control.

The principal negative feedback loop in the real estate system is the ability of the asset market to regulate the flow of financial capital to the development industry.

If either supply or demand threaten to get out of balance in the space market, the resulting impact on asset operating cash flows will trigger pricing reactions in the asset market.

If this reduction is sufficient, it will make additional development unprofitable.

This new development will eventually service the growth in demand and bring rents down to their long-run equilibrium level.

Commercial property markets have been subject to pronounced boom and bust cycles.

However, improvements in asset market efficiency, related to the increased role of the more informationally efficient public capital markets, have provided hope for a more stable future.