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Systems Engineering Procedia 1 (2011) 228–235

Fuzzy Real Option Evaluation of Real Estate Project

Based on Risk Analysis
Yihua Maoa *, Wenjing Wub
ab
Institution of construction management,Zhejiang University, Hangzhou 310058, China

Abstract

The initial investment decision-making of the real estate project is very important. It requires making the right assessment of
engineering project risk, then judging the project potential value which is affected by the risk factors. Within this context, fuzzy
mathematics is used to assess the levels of income risk and cost risk in the real estate investment, and then adjust the relevant
parameters of fuzzy real option based on the above risk assessment of real estate project, which will improve the rationality and
validity of the engineering potential value evaluation. Finally, this paper illustrates the assessment model with an example of a
real estate investment project in Hangzhou.
©
© 2011
2011Published
Publishedbyby
Elsevier B.V.Ltd.
Elsevier Selection and/or peer-review under responsibility of the Organising Committee of The International Conference
of Risk and Engineering Management.
Keywords: real estate investment decision; risk assessment; fuzzy real option; evaluation

1. Introduction

In the whole course of real estate investment and development, it comes along with long construction period,
large capital flows, long payback period, many uncertainties, restriction and influence by policy, which determine
the high risk in real estate investment. So, choosing the right investment project is far more important than
managing. To make the correct choice, a reasonable assessment and measurement of the project risk and value is of
great importance at the early stage in real estate investment. Establishing a set of scientific and effective assessment
methods to identify and analyze the project risk factors to improve the judgment of the potential value, which plays
an important role in ensuring the success of real estate investment.

2. Literature review

The traditional evaluation of real estate investment generally uses net present value (NPV), internal rate of return
(IRR), etc. While these methods fails to take consideration of many uncertainties, and ignore the opportunity value
that is brought by those uncertainties, as well as the flexibility of decision-making. In 1977, Professor Stewart
Myers introduced the financial option theory into real asset areas. The concept of “real option” became popular in

* Corresponding author. Tel.: +86-571-8820-8685; fax:+86-571-8820-8685

E-mail address: maoyihua@zju.edu.cn

2211-3819 © 2011 Published by Elsevier B.V. Selection and/or peer-review under responsibility of the Organising Committee of The International
Conference of Risk and Engineering Management.
doi:10.1016/j.sepro.2011.08.036
 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235 229

our country during the 1990s. Since then it has been widely discussed and successfully used in the theories of
decision making in real estate investment at home and abroad [4-7]. Tang and Lu [4] elaborated the division of real
option type of real estate projects according to the characteristics of real estate projects and real options, and
explained the general framework of real option evaluation. Hou and Qian [5-6] proved the feasibility and rationality
of real option approach applied to real estate project evaluation in connection with the flexible characteristics of
project investment through analyzing some case of commercial and residential real estate using Black-Scholes
pricing model. Compared with the traditional methods, the real options can objectively consider the uncertainties’
effect to real estate potential value and make it more close to reality. But most Black-Scholes pricing model usually
presumes that the cash flow present values of income and cost are definite values, which will affect the judgment
about project values and final decisions if there is a big error in pricing model’s parameters. According to this
problem, Zhao and Tang [8] introduced a fuzzy real option method in which the Black-Scholes pricing model
parameter is set to the fuzzy sets to enhance the accuracy of project assessment results.
Despite above real option pricing models take into account of several uncertain factors of the investment
environment, but the investment income and cost are often obtained by cash flow statement, which can not analyze
and assess the influence on relative parameters caused by risk factors quantitatively and may have a greater
deviation on the overall value assessment of the project. Currently, the project risk assessment research is quite
rich[10-15], produced a considerable amount of assessment tools, and widely used in real estate investment
decisions, such as FAHP, Monte Carlo simulation, Neural network, probability statistics and so on. While these
methods are still limited to risk factors’ analysis and assessment about real estate investment, failed to analyze and
quantify the risk impact on project potential value.

3. The Real Estate Fuzzy Option Evaluation Based on Risk Analysis

In view of the above problem, the purpose of this study is to make a quantitative analysis on the influence of real
estate potential value that caused by the investment risk factors about income and cost. The specific means is to
combine the risk assessment with the relevant parameters of Black-Scholes pricing model of fuzzy real option to
estimate the value of real estate investment project. This paper will identify the risks related to investment income
and cost in the process of the real estate development and use fuzzy mathematic theory to assess these risk factors to
get the corresponding risk level, then adjust the expected estimates of income and cost in the Black-Scholes pricing
model, finally calculate the fuzzy option value of the project and combine the income and cost risk rating to make
investment decision. This method can make the real estate investment evaluation more reasonable and effective that
will provide investors with more feasible basis for decision-making.

3.1. Assessment of Income Risk and Cost Risk

3.1.1. Risk Identification

The most commonly used method for risk identification is risk list. Making the risk list on the basis of the
potential risks of the specific investment project is the first step. There are a large number of researches on risk
identification of real estate investment, and many researchers have classified and discussed the real estate
investment risks. This paper mainly discusses the risk factors that affect the investment income and cost, which play
an important role in real estate value assessment in the process of real estate development. So this paper needs to
chose and analyze several economic risk factors, and select some key factors according to the environment of the
specific project.

3.1.2. Risk Assessment

There are many risk assessment methods to chose. Firstly, this paper adopts expert scoring method to estimate
the likelihood of occurrence of each risk factor and the severity of the consequences may be caused. Next step is to
calculate the average of each risk factor by using fuzzy average operation. In the context, it quotes Ngai’s [3]
presentation about the linguistic term of likelihood and severity to evaluate the risk factors of investment income
and cost. Here, likelihood means the changing probability of the risk factors in the period of investment project
construction. And severity refers to the influence degree of the income fluctuation and cost fluctuation after the
230 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235

project risk factors change. Each linguistic variable are consist of five levels, and the membership functions of the
corresponding fuzzy set are given in table 1.

Table 1. Fuzzy set representation for each linguistic term

Likelihood Severity Membership function

Very unlikely Minimal (0,0,0.25)
unlikely Low (0,0.25,0.5)
Medium Moderate (0.25,0.5,0.75)
Likely High (0.5,0.75,1)
Very likely Critical (0.75,1,1)

Inviting several experts to estimate the likelihood and severity of each income risk and cost risk, after which the
fuzzy average operation is used to balance the results of every expert, making the assessment more objective. If A is
a risk factor, and A=(a 1 i,a m i,a 2 i) presents the risk assessment of expert i. Thus, the triangular average means:

Aaverage
A1  "  An a , a
1
1
1
m  
, a 12  "  a1n , a mn , a 2n  §1 n i 1 n i 1 n i ·
¨ ¦ a1 , ¦ a m , ¦ a 2 ¸
n n ©n i 1 n i 1 ni1 ¹
(1)

3.1.3. Risk Level Calculation

Having obtained the fuzzy average with the likelihood and severity of each risk derived form previous step, the
income risk level and cost risk level can be calculated. This paper uses a common calculation method of risk
analysis, fuzzy weighted average algorithm to estimate the risk level. The fuzzy weighted average is computed as:
m m
W ¦L
i 1
i u Si ¦L
i 1
i

(2)

Where Li is the likelihood of the risk factors, Si is the severity of the risk factors; m represents the number of risk
factors, W represents the overall risk fuzzy sets. As it involves fuzzy sets, the calculating process of weighted
average is complex relatively; the specific methods refer to the literature of Lee and Park [2].

3.1.4. Risk Level Rating

In order to receive more direct judgment of income and cost risk in the process of real estate project development,
it is necessary to translate the risk fuzzy sets back into linguistic terms for more intuitive and clear interpretation. At
the same time, it will make improvement in taking a good master of the project’s feasibility more comprehensive
combined with the following project value evaluation. The paper uses the method of similarity measure between
generalized fuzzy numbers to rate the income and cost risk levels [15]. Compute the similarity S(A, B)between the
risk fuzzy sets and the fuzzy sets for linguistic terms in table 1 respectively; then find out the maximum value of
those similarities to define the risk level. To calculate the degree of similarity, the first step is to get the fuzzy
number’s COG point COG(x*,y*). Because the risk level fuzzy sets in this paper are generalized triangular fuzzy
numbers where A=(a ,b, b, c; w), then

§bb ·
wA u ¨  2¸
* ©ca ¹ w A u (0  2) wA y *A u c  b   (d  a )( w A  y *A ) (3)
y A x *A
6 6 3 2wA

Next step is to calculate the degree of similarity as follows:

 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235 231

4
ª º
S  A, B 
«
«1 
¦a
i 1
1i  a2i »

» u 1  x *A1  x *A2 
B S A ,S B 
u

min y *A , y B* 
« 4 » max y *
A ,y *
B 
«¬ »¼
(4)

Where S (A, B)ę[0,1],and B(S A ,S B ) is defined by

­°1, if S A  SB ! 0 (5)
BS AˈS B  ®
°̄0ˈ if S A  SB 0

Where S A and S B are the lengths of the bases of the generalized trapezoidal fuzzy numbers A and B respectively
defined as follows: S A = c A - a A , S B = c B - a B

3.2. Modification on Fuzzy Real Option BLACK-SCHOLES Pricing Model of Real Estate

3.2.1. Expected Income and Cost Adjustment

Based on the above assessment of risk factors, the income risk level W1 and cost risk level W2 have been gotten.
There are two parameters related to the present value of investment income and cost that must been set in the fuzzy
real option BLACK-SCHOLES pricing model. Combined with the income and cost risk level, this paper makes
adjustment on investment income and cost present value in the model to quantify the influence of these two
parameters, which caused by the corresponding risk factors. Chen [9] has given the adjustment formula:

V ' V  E (V )W1 C ' C  E (C )W2

(6)

Where V is the value of the initial project estimated income and C is of the expected cost those are all fuzzy sets;
While V’ and C’ are represented for adjustment values; E(V) and E(C) are the probability averages of the initial
income and cost. To determine the average of fuzzy sets, Carlsson C. and Fuller R. [1] gave the computation
formula as follows:
1 1 a (J )  a (J ) 1
E ( X ) ³ J >a1 (J )  a2 (J )@dJ ³ J 1 2
dJ ³ JdJ
0 0 2 0

Where X=(x, Į ȕ is a triangular fuzzy number in the context (see figure 1), then

1 (7)
E( X ) x E  D 
6

Probability

0 x-Į x x-ȕ cash flow

Fig. 1. The distribution of cash flow present value

232 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235

3.2.2. Modification on fuzzy real option pricing model

A fuzzy real option Black-Scholes option pricing model was proposed by Zhao and Tang [8], to which this paper
refers to obtain the following modified fuzzy real option Black-Scholes pricing model of real estate linked to the
adjusted fuzzy value of expected income and cost that based on the risk factors assessment.

FROV V ' e GT N (d1 )  C ' e  rT N (d 2 )

(v ' e GT N (d1 )  c ' e rT N (d 2 ),D v e GT N (d1 )  E c e rT N (d 2 ), E v e GT N (d1 )  D c e rT N (d 2 ))
(8)

Where,
ln>E (V ' ) E (C ' )@  (r  G  V 2 2)T (D v  E v ) 2
d1 , d2 d1  V T , V (V ' )
V T 24

4. Case Study

4.1. Project Overview

In the early 2009, a real estate enterprise planned to develop a residential project in Binjiang district of
Hangzhou. Before the land auction it needs to work out an investment feasibility study to determine whether to
participate in the project development. Because of the global financial crisis, the Hangzhou real estate market is also
affected. This project investment is confronted with many uncertain factors. And it is hard to determine the future
returns and costs, which means the market risk is greater, so it is of great importance to estimate the potential value
of this project.
The project feasibility report predicted that the investment construction was three years. According to the
project’s cash flows (see Appendix A) and the average yield of 12% of the real estate, the report estimated the
present value of this investment income was 1,425,184,500; and the cost was 1,483,644,200. Meanwhile,
considering 10% fluctuation proportion, the initial estimated income and cost fuzzy sets can be expressed as
V=(1425184500,14000,14000), C=(1483644200,15000,15000)

4.2. Fuzzy Option Evaluation of Real Estate Project Based on Risk Analysis

This real estate investment faces a variety of risks, in the study we focus on the risk factors associated with
income and cost. On the basis of market environment, this case selects several mainly economic risk factors and
takes the policy influence into consideration. The income risk factors consist of ķthe inflation rising rate, ĸtax
rate changes related to the real estate industry, Ĺinterest rates fluctuation of the bank loan, ĺmarket supply and
demand in Hangzhou, Ļthe government housing policy, ļhousing prices in Hangzhou. When it comes to the cost
risk, the first three risk factors are the same and there are other two factors, ĺthe fluctuation of construction
development expense and Ļthe project management skills.
In this case, inviting seven assessors to estimate the above income and cost risk factors, due to restrictions, each
assessment results can not listed. According to the formula (1), the average fuzzy sets of the likelihood and severity
of risk factors are showed in below tables.
After that, using fuzzy weighted average method to calculate the income and cost risk levels of this investment
project. Based on the formula (2), we can obtain the income risk and cost fuzzy sets as follows:
Wv (0.2255,0.4492,0.6733) Wc (0.2004,0.3955,0.7830)
So we can also obtain the degree of similarity between the income and cost risk fuzzy sets and linguistic terms to
rate the risk level through using the formulas (5)-(7), the results are provided in table 4:

Table 2. Average fuzzy set of likelihood

 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235 233

Risk factors Likelihood Severity

ķ (0.4286,0.6786,0.8571) (0.2143,0.4286,0.6429)
ĸ (0.2857,0.5357,0.7857) (0.2143,0.4643,0.7143)
Ĺ (0.3214,0.5714,0.8214) (0.1071,0.3571,0.6071)
ĺ (0.1786,0.4286,0.6429) (0.3571,0.5714,0.7500)
Ļ (0.4643,0.7143,0.9643) (0.5714,0.8214,0.9286)
ļ (0.2143,0.4286,0.6429) (0.5714,0.8214,0.9643)

Table 3. Average fuzzy set of severity

Risk factors Likelihood Severity

ķ (0.4286,0.6786,0.8571) (0.3929,0.6429,0.8571)
ĸ (0.2857,0.5357,0.7857) (0.1786,0.4286,0.6786)
Ĺ (0.3214,0.5714,0.8214) (0.2143,0.4643,0.7143)
ĺ (0.3929,0.6429,0.8929) (0.6071,0.8571,0.9286)
Ļ (0.1786,0.3571,0.6071) (0.2500,0.5000,0.7143)

Table 4 (a) The similarity between income risk and linguistic term; (b) The similarity between cost risk and linguistic term

S˄income risk, minimal˅ 0.3888 S˄cost risk, minimal˅ 0.3860

S˄income risk, low˅ 0.6411 S˄cost risk, low˅ 0.6374
S˄income risk, moderate˅ 0.9012 S˄cost risk, moderate˅ 0.8896
S˄income risk, high˅ 0.4890 S˄cost risk, high˅ 0.4922
S˄income risk, critical˅ 0.2726 S˄cost risk, critical˅ 0.2748

From table 4, it can be seen that the maximum value of similarity between income risk and linguistic term is
0.9012, so the income risk level is moderate. And similarly, the cost risk level is moderate, too.
1 1
E (V ) 1425184500  14000  14000 1425184500 E (C ) 1483644200  15000  15000 1483644200
6 6
Then next step is to adjust the income and cost values of this investment combined with the risk fuzzy sets. The
initial expected income and cost respectively is:
1 1
E (V ) 1425184500  14000  14000 1425184500 E (C ) 1483644200  15000  15000 1483644200
6 6
And the adjusted values are:
V ' V  E (V )Wv (325607800,784991600,1243805400) C ' C  E (C )Wc (171950800,896862900,1336321900)

We should transfer the results into triangular fuzzy sets: V’= (784991600, 459383800, 458813800), C’=
(896862900, 724912100, 439459000).
So the averages of fuzzy sets are also calculated as follow:
1 1
E (V ' ) 784991600  458813800 - 459383800 784896600 E (C ' ) 896862900  439459000 - 724912100 849287400
6 6
Finally apply the fuzzy real option Black-Scholes pricing model to evaluate the potential value of this project.
Other parameters in the model are defined as follow: the option deadline is 2 yeas, because of the limitation draw up
by our country land administration; the risk-free rate can be taken as 2.9% in accordance with one-year treasury
interest rate in 2008; the delay cost rate should be computed as follows: į= land cost ratio × loan rate + construction
cost ratio × construction cost growth rate, and in this case, the value of the delay cost rate is 0.0533.
Proposed by Zhao and Tang [8], the standard deviation of expected return is defined as:
234 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235

V (V ' )
(D v  E v ) 2 459383800  4588138002 187426300
24 24
So, we can obtain the fluctuation ratio ³=187426300/784991600=23.87%
Then,
ln>E (V ' ) E (C ' )@  (r  G  V 2 2)T
d1 0.2087 d2 d1  V T 0.5463
V T
At last, the fuzzy option value is
FROV V ' e GT N (d1 )  C ' e  rT N (d 2 ) (60000184,293615479,372191752)
Where, the average expected investment value E(FROV) is 73,096,229.

4.3. Results Analysis

From above calculation results, it can be seen that the triangular fuzzy option value (-233615295, 60000184,
432191936) represents the potential value distribution of this project. The negative value illustrates that change of
these risk factors may bring losses that can not be compensated by the project income. And the ENPV of this project
is computed as: E(V’)-E(C’)+E(FROV)=8705429>0, what indicates that the project still have the investment value.
Meanwhile, comprehensively, after considering the risks levels of investment income and cost are all medium, this
investment plan of residential project is feasible.

5. Conclusion

The common evaluation methods of real estate investment usually just calculate and estimate the risk factors, and
fail to analyze the influence on the potential value of engineering development project, while the real option method
provides a better tool to solve the problem. However, in the Black-Scholes pricing model, there exist quite numbers
of uncertainties when determining the two parameters of income and cost in real estate investment because there are
so many risks that will effect them. This paper combines the fuzzy risk assessment of investment income and cost
with the calculation of relevant parameters in fuzzy real option pricing model, through quantitative analysis, making
the expected values of real estate project’s income and cost more reasonable and realistic and improving the
reliability of the potential value evaluation. At the same time, combined with the income and cost risks levels rating,
we can judge the feasibility of the project synthetically. The paper analyzes an example of a real estate investment
project in Hangzhou to apply to this evaluation method. This method can provide a theoretical reference for real
estate investment decision-making.

Appendix A.

Table 5. The cash flow chart of this residential project

Construction period
Serial number Item
0 1 2 3 4
1 Cash inflow 0 0 1120680000 747120000 0
1.1 Sales revenue 0 0 1120680000 747120000 0
2 Cash outflow 834663600 37673300 279548900 348000000 227829200
2.1 Land cost 834663600 0 0 0 0
2.2 Pre-project cost 0 37673300 0 0 0
2.3 Construction investment 0 0 175886000 278891400 227829200
2.4 Land value increment tax 0 0 11206800 7471200 0
2.5 Taxes and add 0 0 64439100 42959400 0
2.6 Income tax 0 0 28017000 18678000 0
3 Net cash flow -834663600 -37673300 841131100 399120000 -227829200
 Yihua Mao and Wenjing Wu / Systems Engineering Procedia 1 (2011) 228–235 235

Note:
1) The period of from getting land to obtaining the four construction certifications is the upfront investment of
this project that lasts one year, and the construction period is three years.
2) This residential project adopts presales system what allows developers to sell residential houses prior to the
completion of construction. During the first year of this construction period, the presales are expected to reach 60%,
and the remaining 40% can be finished in the second year.

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