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 (rent) 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, which are the fundamental subjects of the asset market.

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, those currently on the “buy” side and those currently on the “sell” side, either in general or for specific assets.

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

Investors’ desires and perceptions about the investment risks and returns of real estate assets, as compared to other types of investment opportunities available elsewhere in the capital markets, determine the current market cap rates investors require in real estate deals.

A key determinant of cap rates is also investors’ forecasts about the future of the relevant space market, on both the demand and supply sides, so as to predict the likely future course of rents.

Thus, we see how the space and asset markets, reflecting the underlying economic base and the capital markets, interact to produce 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 box in the exhibit.

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 site 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 cost at the time of completion of the project, which may take several years.

Indeed, the real estate system depicted in Exhibit 1-1 is, in principle, forward-looking to varying degrees in several aspects of the system.

Not only must developers be forward looking to account for construction time, but the space market is also forward-looking in that many users of space require long-term planning for their space needs and much space is rented out under long-term leases lasting typically from two to ten years.

But the greatest incentives for peering into the long-run future probably reside in the asset market part 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 perception about the future.

Fundamentally, when you “unfold” each subsequent sale transaction of a given asset, you realize that the present value of the asset depends ultimately on the entire future stream of cash flow the asset can generate into the infinite future.

To forecast future income streams from the real estate assets they are holding or considering buying, investors must forecast both the local economic base underlying the demand side of the space market and the activity of the development industry on the supply side of the space market.

They must also attempt to forecast capital-market and national macroeconomic factors, such as interest rates, inflation, and investor preferences, all of which affect the opportunity cost of capital and therefore the future values of assets.

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 effect on assets’ operating cash flows will trigger a pricing response in the asset market.

For example, if new development threatens excess supply in the space market, investors will expect lower future rents, which will cause a reduction in property market asset values today.

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

On the other hand, if usage demand for space grows without addition of supply, occupancy and rents will be pushed up in the space market, increasing current cash flow in the asset market and pushing up prices there until new development is triggered.

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

If the participants in the system are sufficiently forward-looking and quick in their reactions, the negative feedback loop in the real estate system can keep built space supply and demand in pretty good balance most of the time.

Of course, the real estate system has not always operated exactly like a well-oiled machine in this regard.

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

However, during the 1990s, improvements in asset market efficiency, related to the increased role of the more informationally efficient public capital markets, gave hope that the system may work better in the future.