1.2 Nomenclature of Knowledge
“The nature of commercial real estate investment is cross-sectional in nature, taking multiple disciplines and approaches to solving the valuation equation.”
Commercial real estate is a very complex asset class and the investment process is costly and time consuming. However, an institutional approach to solving the valuation equation is not only a necessary condition, but can also be sufficient. An institutional analysis of commercial real estate valuation can be built on eight core social science disciplines: accounting, finance, economics, public administration, politics, law, philosophy and theology. For example:
• All functions of management and administration require managerial (cost) and financial accounting (reporting) for performance evaluation and budgeting, this is also required for external funding requirements;
• From the accounting process, financial ratios and statements are produced to meet lender and sponsor requirements, and depending on the performance, may be able to access capital at costs below internal rates of return;
• The ability to access capital markets and develop economically, is based on the dynamics and constraints imposed by the political economy (representative democracy, capitalism, socialism, communism, etc.); this is represented in comparative industrial, monetary and fiscal policy regimes;
• These policies and economies are administered via standard bureaucratic (public vs. private) institutions, organizational structures designed to produce public and private good with intended (or unintended) outcomes;
• The legal system, based on European western civil philosophies, sets president and moral, ethical, equity and justice as the foundations for decision making;
• Philosophical, legal, political and public administrative institutions are based on theocratic systems of administration developed thousands of years ago.
The objective of understanding the relationship and inter-relationship between these institutions (equations) -- and their independent variables (factors) – is the ability to accurately forecast the magnitude and direction of total return (income and capital appreciation) and volatility (risk) – risk adjusted -- at both the institutional property and portfolio level.
The caveat in solving for value, is under standing that any movement in any one variable – variables can also be in more than one equation – can cause variables in another equation to move. Therefore, there is systematic (institutional) risk (cross correlation) among independent variables across the system.
Nomenclature of Knowledge (Solving Valuation Equation)
The challenge with this inter-institutional (input-output) approach is that most social science institutions (equations) have upward of 50 variables each, plus an error term; so to solve eight equations with +50 variables each, would require solving thousands of combinations, simultaneously. This would require massive data collection, storage, manipulation and programming efforts.
Although, solving the valuation equation for commercial real estate, using an inter-institutional approach in practically impossible, it is theoretically correct, and should be attempted in a limited form; and integrated into standardized and systematized due diligence and ongoing hold-sell processes for optimal property selection and portfolio diversification decision making.
The nomenclature of knowledge sets a basic framework for understanding the dynamics that drive commercial real estate values and investment decisions. This system of analysis can also be scaled and applied to the micro-economic level, assessing risks and returns on property and portfolios by sector and property type and by geographic area or submarket.