iBusiness, 2013, 5, 41-46
http: //dx.doi.org/10.4236/ib.2013.53B009 Published Online September 2013 (http://www.scirp.org/journal/ib)
41
Risk Decision Analysis of Commercial Real Estate
Guodong Liu1, Xiuli Tang2
1College of Economics and Management, China Agricultural University, China, 100083; 2School of Logistics, Beijing Wuzi Univer-
sity, China, 101149.
Received May, 2013
ABSTRACT
With the increasing of construction of logistics parks, it is essential for commercial real estate project to study on risk
decision to avoid redundant and blind construction. Based on risk essence, the paper analyses the attitude of investment
decision-makers on risk benefits. Finally, the paper improves the expected utility theory and applies the prospect theory
to risk decision of commercial real estate project to provide scientific and objective basis for Project Investment Deci-
sion.
Keywords: Commercial Real Estate; Project Investment; Risk Benefit; Prospect Theory; Risk Decision
1. Introduction
The commercial real estate is a multidisciplinary and
multi-industry comprehensive and cross complex with
wide coverage and high technology content. Its structure
is complicated and uneven with strongly relevance with
each other, which makes the construction of commercial
real estate have characteristics of large investment capital,
long development period, high technical requirements,
many influencing factors, long-term effects and others.
Therefore, the construction of commercial real estate is
complicated system engineering, and the manager will
face many risk factors and decision problems from the
project approval to the delivery and use of project.
For an uncertain event, the previous researches em-
phasize that the manager should adopt correct risk analy-
sis and decision methods. Therefore, theoretical methods
on this aspect are becoming more and more improved
and have been applied in practice to some extent. How-
ever, practices indicate that one successful risk decision
depends on that whether the decision maker will chose
reasonable risk analysis methods and decision methods,
as well as on the decision maker’s personal attitudes on
risk, his personal experiences, ability, characters and
other factors. However, the latter factors are seldom in-
volved in past researches on risk decision methods.
2. Nature of Risk
In investment activities, when the investors make risk
decisions, most of them pursue the risk benefits under
uncertain conditions, i.e. unexpected excessive benefits
and unexpected loss of benefits which might be borne.
Quantitatively, the risk benefits will be reflected as the
positive and negative differences between the benefit
bodies’ expected benefits and actual benefits.
Therefore, the risk decisions are usually made on the
basis of risk benefits, and we will discuss the nature of
risk in the following paragraphs.
When people analyze decisions, the nature of risk is
risk benefit. Therefore, in actual investment activities and
all decisions are around benefit. If there is no expected
benefit, few investors will make risk decisions, therefore
risk is risk benefit in nature. In past definition of risk,
people used to emphasize the uncertainty of risk losses.
In Economic Risk Theory, Wu Ming thinks that in the
production and circulation of commodities, all kinds of
unexpected (uncertain) factors might cause differences
between the commodity producers and marketers’ actual
benefits and expected benefits, bringing opportunities or
possibility for them to suffer economic risk losses or ob-
tain extra benefits. In Risk Benefits Theory, Ma Yan de-
fines the nature of risk as: ① The fundamental reason
for making risk decision is the uncertainty of benefits.
② The risk itself is the change process of uncertainty of
benefit. ③ The results of risk process are results of un-
certain benefits. ④ The risk avoidance originates from
the uncertainty of benefits[1].
Risks exist objectively, which are only different in
different construction projects on certain degree. How-
ever, even for one given investment project, and the size
and degree of risk are certain, different decision makers
of commercial real estate construction might choose dif-
ferent risk decision modes due to their different risk
benefit preferences. At the same time, we can say that the
amount of unexpected extra benefits that risk decision
makers hope to obtain and amount of unexpected benefit

Risk Decision Analysis of Commercial Real Estate
42
losses that risk decision makers are ready to bear have
primarily determined the construction direction and
mode of commercial real estate. Therefore, after risk
analysis, it is necessary to dig the risk decision makers’
risk benefit preferences and effects. Only making risk
decisions from the angle of the investors has concrete
application value.
The famous Nobel Prize Winner in Economic Sciences
Arrow has divided people’s attitudes towards risk into
three types: risk preference type, risk aversion type and
risk neutrality type.
Here in this article, to facilitate the theoretical analysis,
the attitudes of risk benefit main bodies are divided into
three types:
The preference type refers to that the risk decision
makers have great hope on the relatively higher risk gain
in commercial real estate construction activities, and to
fulfill this hope, they are ready to take great risks while
neglect the risk losses.
The aversion type refers to that the decision makers in
commercial real estate construction might obtain risk
gain, but as long as certain risk exists, they are willing to
obtain the risk benefits for correspondent part of risk,
rather than bearing the risk losses.
The neutrality type refers to people between the
above-mentioned two types of people. When making risk
decisions on commercial real estate construction, they
are neither willing to take risks to obtain risk benefits,
nor passively avoid the risk gain, but they take neutral
attitudes, usually choose a neutral value between the risk
benefit and risk loss.[2]
3. Expected Utility Theory
The risk benefit attitude refers to the decision maker’s
subjective attitudes towards risks, which is insistent with
people’s utility concepts. Therefore, the risk attitude can
be measured with the utility. The “utility” under general
meaning refers to psychological satisfaction or satisfac-
tory degree that people produce since they own or use
certain articles. In this article, the decision maker’s sub-
jective sense on risk benefit is called as “utility”. In the
rectangular coordinate system, if the horizontal coordi-
nate X refers to risk benefit (risk gain +RR, risk loss-
RR), and the vertical coordinate refers to the Utility U of
risk results (x), we can draw the risk utility curve.
Different risk decision makers’ risk benefit prefer-
ences cause the diversity of different decision makers’
utility functions and the utility curve might differ in
thousands of ways. The above-mentioned three types of
people who have different attitudes towards risk benefits
must have three different utility concepts. If these differ-
ent utility concepts are reflected on the utility curve, we
can draw three different utility curves, see Figure 1.
-RR +RR
Utility value U(x)
Neutrality type
Preference type
Aversion type
Figure 1. Utility curves of different risk preferences.
Through comparison of three curves in the figure we
can see that: faced with risk decision, people who disgust
risk benefits are relatively sensitive to risk losses, while
react to risk gain slowly. They do not seek huge profits,
but try to avoid risks. On the contrary, people who prefer
risk benefits are relatively sensitive to risk gain, while
react to risk losses slowly. They are bold to pursue risk
benefits. The risk benefit neutral’s decision-making be-
havior is between the above-mentioned two. They hold
neutral attitudes towards risk benefits, will neither exces-
sively pursue risk gain, nor excessively avoid risks.
4. Application of Prospect Theory in Risk
Decision in the Commercial Real Estate
Investment Constructio n
4.1. The Prospect Theory has Improved the
Utility Theory
The above analysis is just under ideal conditions, while
in actual commercial real estate construction activities,
the risk decision makers’ attitudes towards to risk bene-
fits are not unchangeable. They might belong to risk
benefit preference type when faced with certain risk, or
belong to risk benefit aversion type when faced with
other risks. In same investment activity, some people
might prefer the risk gain completely, while they do not
consider the risk losses. At the same time, no people will
consider the risk gain without aversion of risk losses.
People’s basic objectives for risk decision are: how to
reach the most satisfactory risk gain at the time or reduc-
ing the risk losses minimally as possible. In reality, what
about most people’s risk benefit preferences and utility.
In the following paragraphs, we will discuss these issues
with the introduction of Prospect Theory.
Since 1970s, a great number of empirical researches
have indicated the complex of people’s decision behav-
iors, and new theoretical analysis is in urgent need to
guide people’s decision behaviors. The 2002 Nobel Prize
Winner in Economic Sciences Dainiel Kahneman and
Amos Tvrsky have officially put forward the new Pros-
pect Theory on risk decision in 1979 on the basis of

Risk Decision Analysis of Commercial Real Estate 43
complex of people’s decision behaviors and in combina-
tion a great number of with their own psychological re-
searches. [3]
The Prospect Theory has effectively combined the
psychological researches and economical researches,
revealed the decision mechanism under uncertain condi-
tions and developed a new research field. Based on a
great number of empirical researches, the Prospect The-
ory has raised lots of valuable laws. Generally, there are
three basic laws in the Prospect Theory: (a) most people
belong to risk avoidance type when faced with gain; (b)
most people belong to risk preference type when faced
with losses; (c) people are more sensitive to loss than to
gain.
Through the above analysis and application of it into
Utility Theory, in the article we get the utility curves of
most people’s risk benefit preferences as demonstration
in Figure 2:
Curves of most people’s risk utility functions are “S”
type, therefore, we can see that most people belong to
risk aversion type when faced with risk gain, while be-
long to risk preference type when faced with risk losses.
They are more sensitive to risk loss than to risk gain.
For example: one investment company is faced with
two commercial real estate investment program (A is on
hotel, B is on office building), and the company’s funds
are only enough for investment on one of the two.
Through risk analysis, the probability to gain RMB 10
million Yuan through Program A is 1, while probability
to gain RMB 20 million Yuan through Program B is 0.5
and the probability to gain no benefits is also 0.5.
Though the expected value of the two Program is same,
most decision makers with choose Program A, which
indicates that faced with rise gain, most decision makers
belong to risk aversion type. If the decision maker of the
investment company is faced with the two following de-
cisions, probability to loss RMB 10 million Yuan
through Program A is 1, probability to loss RMB 20 mil-
lion Yuan through Program B is 0.5 and the probability
to suffer no loss is also 0.5. The expected value of the
C
Utility curves of most people’s
risk benefit preferences
B
A
0 +RR
-RR
Utility value U(x)
Figure 2. Utility curves of risk benefit preferences.
two decisions are same, while most decision makers
choose Program B, which indicates that faced with risk
loss, most decision makers belong to risk preferences.[4]
In actual risk decisions, the loss and gain are not ab-
solute. People avoid risk when faced with gain, while
prefer risk when faced with loss. However, the Prospect
Theory also indicates that the loss and gain are in relative
to the reference point. If people’s viewpoints on assess-
ment of things change, change people’s risk attitudes will
also change.
For example, when the investment company is faced
with the above two investment decisions, if the probabil-
ity to gain RMB 20 million Yuan through Program A is 1,
while the probability to gain RMB 30 million Yuan
through Program B is 0.5 and the probability to gain
RMB 10 million Yuan through Program B is also 0.5. At
this time, if the profit goal of the investment is relatively
low, for example RMB 10 million Yuan, it seems that the
company can gain extra RMB 10 million Yuan through
Program A, while the company can either just reach its
gain goal or gain extra RMB 20 million Yuan through
Program B. It seems the company will gain no matter
adopting Program A or Program B. at this time, most
employees are unwilling to take risks and they will
choose Program A. On the contrary, if the company goal
is relatively high, for example RMB 30 million Yuan,
then the company will either gain less RMB 10 million
Yuan through Program A, or will just reach the goal or
gain less RMB 20 million Yuan through Program B. At
this time, the company will suffer loss through both pro-
grams; most employees will take risks to choose the risk
investment Program B thinking that they might reach the
goal. Therefore, the investment risk decision maker can
completely change employees’ attitudes towards risks
through changing of their profit goals.
Therefore, the above case indicates the importance of
utility function, and the utility values of same expected
value are different under different environments or dif-
ferent reference points.[5]
4.2. Application of Prospect Theory
The utility curves of different risk decision makers are
different, even the same risk decision maker might pro-
duce different utility curves due to different environ-
ments. However, in this article, we only discuss the ap-
plication under utility curves of most investment decision
makers.
The utility function curves can be gathered through
questionnaire surveys, inquiries, psychological tests and
other methods, among which the most common abroad is
the Von Neumann Method.
This method was raised Von Neumann and Oskar
Morgenstern in the book The Theory of Games and

Risk Decision Analysis of Commercial Real Estate
44
Economic Behavior that they jointly issued in 1944. Ac-
cording to this method, the deterministic profit and loss
value equal with the risk expected profits and loss are
obtained through psychological tests, which are used as
standards for one-time decision. Generally, this method
is also called as standard gamble method, the NM
Method for short.
It generally includes two steps to determine the utility
functions through the NM Method: the first step is to
determine two risk benefits values as the reference points
and the utility values of the two points. Generally 1 is
used to indicate the maximum utility value of optimal
result, 0 indicates the minimum utility of worst result.
The second step is to determine the utility values of all
other benefits between these two extreme risk benefits.
According to the NM Method, the determination of util-
ity value is on the basis of concept of equivalence point
and others. The decision maker should choose from the
following two programs.
Program A: gain risk benefit X1 through probability p,
at the same time, gain benefit X2 through probability 1-p,
and the correspondent given utility values are respec-
tively U(X1) and U(X2).
Program B: to gain benefit X3 through probability of
100% (X1 <X3< X2).
To determine the equivalence point between Program
A and Program B, we can adjust the benefit value X3 of
Program B and inquire the decision maker repeatedly,
until the utilities of Program A and Program B are equal
to the decision maker, that is to say, we have find the
equivalence point X3 and made U(X3) =p*U(X1)+(1-p)*
U(X2).
Through the NM Method, we can calculate the utility
function of risk decision makers’ attitudes towards risk
benefits, that is to say, express the risk attitudes of deci-
sion makers through quantitative mode, thus calculate the
expected utility value and determine the optimal program
for risk decision. In the following paragraph, we will
introduce the concrete application through examples.
One investment company has obtained a plot of good
land through competitive bidding, and there are three
investment programs for this plot of land: the first one is
to construct hotel property. The second one is to con-
struct office buildings, and the third one is to develop
combined property, which will be transferred under legal
permissions after certain time. The market conditions and
risks for each development program are different from
those of others and the risk benefits to be gain are also
different from others. Through risk analysis, we can get
the risk benefits and probabilities for the risk benefits to
happen of the above-mentioned three development pro-
grams, as demonstrated in Table 1, Table 2 and Table 3.
According to principle of NM Method, suppose the
maximum utility value of risk gain is 1 under the whole
risk environment, which is U (X = 2.5 million) = 1; the
maximum utility value of risk loss is 0, which is U (X =
-1.0 million) = 0; the utility value of others are deter-
mined through the utility curves determined according to
the NM Method, we get data as demonstrated in Table 1,
Table 2 and Table 3. Through data in the tables we can
calculate the risk decision maker’s expected utility value
for three programs and their choices of risk programs.
The risk benefit preference utility curves as Figure 3:
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-100 -50050100150200250
U
t
i
l
i
t
y
v
a
l
u
e
U
(
x
)
Risk benefit(10,000Yuan)
Figure 3. Risk benefit preference utility curves.
Table 1. Risk benefits, probability and utility value in pro-
gram 1.
Risk benefit
(10,000Yuan) -100-500 50 100 150 200250
Probability value
Utility value
0.05
0
0.05
0.12
0.1
0.4
0.1
0.7
0.15
0.88
0.15
0.94
0.35
0.98
0.05
1
Table 2. Risk benefits, probability and utility value in pro-
gram 2.
Risk benefit
(10,000Yuan) -50 0 50 150 200
Probability value
Utility value
0.05
0.12
0.1
0.4
0.1
0.7
0.55
0.94
0.2
0.98
Table 3. Risk benefits, probability and utility value in Pro-
gram 3.
Risk benefit (10,000Yuan) 100
Probability value
Utility value
1
0.88

Risk Decision Analysis of Commercial Real Estate 45
Expected utility value of Program 1:
EUV1=0×0.05+0.05×0.12+0.1×0.4+0.1×0.7+0.15×0.8
8+0.15×0.94+0.35×0.98+0.05×1=0.914
Expected utility value of Program 2:
EUV2=0 .05×0. 12+0. 1×0.4 +0.1×0 .7+0 .55×0. 94+0. 2×0
.98=0.829
Expected utility value of Program 3:
EUV3=0.88×1=0.88
According to the principle of priority to expected util-
ity optimal one, most decision makers choose Program 1
as the optimal program. [6]
Of course, the above statements are just the analysis of
decision behaviors that the utility curves of most risk
decision maker’s risk benefit preferences are obtained
according to the Prospect Theory. However, different
people have different risk preference utility curves, in
reference to the above methods, we can draw the risk
utility curves of difference people (risk preference type,
risk aversion type and risk neutrality type) according to
concrete environments of project investment and differ-
ence people’s attitudes towards risk, and calculate the
expected utility value to guide risk decision-making.
Since we cannot determine the utility function curves
precisely, the risk management personnel of commercial
real estate should not depend much on this method to
make risk decisions under circumstance that there is
small difference between the expected utilities. However,
since the expected utility theory points out people’s atti-
tudes towards risk benefits, and their attitudes to measure
the risk benefits they face with utility, it’s an effective
method. This method is not only limited to application in
risk decisions in commercial real estate construction, but
also can be applied in all project risk decisions.
The Prospect Theory is the further research of Utility
Theory, according to the Prospect Theory: first, people’s
decision-making process can be divided into two steps:
the first step is the occurrence of random event and peo-
ple’s collection and classification of the results of event
and related information. The second step is to assess the
decision.
Second, the risk decision makers do not care the abso-
lute value of wealth itself, but care the relative variable
quantity W of wealth relative to the reference point. This
reference point is usually the decision makers’ current
wealth level, and the decision maker defines the gain and
loss in comparison to the reality. However, this reference
level might be certain desirable level, which refers to the
wealth level that the participators work hard to gain un-
der current given wealth and expected conditions.
Third, the difference between the Prospect Theory and
Utility Theory is that the value function is not equal with
the utility function. According to the Prospect Theory,
people’s utility is described through two variables:
weighting function and subjective value function. The
weighting function ∏（p）describes the impact of change
of probability of single event on the overall utility in fu-
ture Prospect Theory. the subjective value function V（x）
directly reflects the relationship between the prospect
result x and the size of people’s subjective satisfaction.
In the Prospect Theory, the value function curve is as
demonstrated in Fi gu re 4:
In the value function of Prospect Theory, there is one
reference point for increase of decrease of wealth, and
the position of this point depends on the decision makers’
subjective impressions. The value function is notching
under the profit domain, while is protruding downwards
under the loss domain. What the value function demon-
strates is that with the same difference of 5 dollars, the
difference of subjective value between 10 dollars and 15
dollars is larger than the difference of subjective value
between 10 dollars and 105 dollars. Under circumstance
of losses, this nature still exists.
According to the Prospect Theory, people’s attitudes
towards risks not only depend on the utility function, but
is also decided jointly by the value function and weight-
ing function. In this article, we only study the impact of
Prospect Theory on risk decisions, and the concrete
quantitative methods will be discussed in future study.
Through the above-mentioned joint study and application
of Prospect Theory and Expected Utility Theory, we can
summarize the laws of most decision makers’ decisions
when faced with risk.
When the commercial real estate construction decision
makers makes risk decisions, they are easy to overesti-
mate the small probability events while underestimate
large probability events. They usually belong to risk
avoidance type when faced with risk gain, while belong
to risk preference type when faced with risk loss, and
they are more sensitive to risk loss than to risk gain.
When the decision maker is faced with risk, he should
not only consider the risk utility, but the decision-making
is also related to the decision makers’ wealth condition,
the incentive and restraint system. They consider the
relative variable quantity of wealth more. When the in-
vestment operation fails, especially is close to bankruptcy,
Value
Loss
Profit
Figure 4. Value function curve.

Risk Decision Analysis of Commercial Real Estate
46
the decision maker usually tends to take a risk when
faced with risk. On the contrary, when the investment
operates smoothly, the decision maker usually tends to
avoid the risk when faced with risk.[7]
5. Conclusions
The commercial real estate project is characterized by
large investment, long period and long-term effect, with
relatively big risk. To avoid the reconstruction of com-
mercial real estate project and effectively stop blind con-
struction, it is extremely necessary to study and analyze
the risk decision problems of property project. In this
article, we introduce the Prospect Theory into the risk
decision in commercial real estate investment through
analysis of decision makers’ risk attitudes and prefer-
ences. The Prospect Theory can better reflect reasonable
people’s decision behaviors under uncertain risk condi-
tions, thus can make the investment decision on com-
mercial properties more scientific and more objective.
This theory can also be applied in the risk decision of
other investment projects.
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