According to The Appraisal Institute, the highest and best use of a property is defined as: The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value. The Appraisal Institute defined a set of tests known as The Four Tests, that comprise the factors an appraiser must consider when determining the highest and best use of a property. In this article highest and best use for your property we will examine these four tests, and what is legally permissible, physically possible, financially feasible and maximally productive. This will be kept in the scope of residential real estate, and we welcome the opportunity for you to reach out if you have further interest. Let’s dive in!
Highest and best use, or highest or best use (HBU), is a concept that originated with early economists such as Irving Fisher (1867-1947), who conceptualized the idea of maximum productivity. One of the earliest citations of the term is found in the Minutes of the Maine Legislature as early as 1831 in speaking about the assessment and valuation of real estate: “…the land was classified preceding such change of use, had such real estate been assessed at its highest and best use…”
It is the concept in real estate appraisal that shows how the highest value for a property is arrived at. In any case where the market value of real property is sought, that value must be based on its highest and best use. Highest and best use is always that use that would produce the highest value for a property, regardless of its actual current use. The economic concepts of utility and substitution drive the highest and best use analysis. The highest and best use of a property determines its utility to a potential purchaser. A purchaser will pay no more for a property than a competing property with the same utility would command, while a seller would accept no less than another seller of a comparable property.
- Legally permissible – Which use cases are permissible by law, zoning, and other land use regulations.
A prospective use cannot be considered the highest and best use unless that use would be allowed under:
- Current building codes
- Zoning ordinances
- Environmental laws
- Other government regulations
If building in a residential area with restrictive covenants, the proposed improvements must not violate any rules. The proposed use must conform to all applicable building codes and height limits. In addition, the improvements must adhere to any restrictions imposed by easements on the property. Determining whether a proposed use is legally permitted requires research into the local building regulations and restrictions. Gaining a comprehensive understanding of the applicable legal requirements can be time-consuming, but it is fairly easy to determine whether or not a proposal violates any of these regulations.
2. Physically possible – Constructing buildings on the side of a mountain or in a swamp probably aren’t possible.
Taken into consideration must be the topography, soil type and conditions, lot size and shape, surface and subsurface water, and even weather, and fire hazard zones. An appraiser must consider the proposed use of the site, and also the characteristics of the optimum improvements for that use.
3. Financially feasible – Does the use case of the property suit the demographics and market of the area well?
Financially feasibility goes hand in hand with conducting a market analysis and developing a proforma cash flow estimates. You’ll need to collect data in order to forecast construction and development expenses. Data such as:
- Operating expenses
- Absorption rates
- Vacancy rates
- Discount rates
- Cap rates
- Residual values
After gathering this information, estimate the proforma net operating income over your expected holding period. Employing discounted cash flow techniques, you can determine which projects meet your particular investment standards.
Discounting cash flows by your cost of capital and computing the net present value, a project is considered financially feasible if the NPV is greater than 0. You can also compute the internal rate of return and compare the property’s return to your acceptable hurdle rate for projects. If your property meets this important feasibility, you can continue towards whether it is maximally productive.
4. Maximally productive – Does the intended use optimize the potential of the land?
The previous steps eliminated proposed uses that were not physically possible, legally permissible, or financially feasible. The last step takes all of the proposed uses that meet these requirements and ranks them in order of value or rate of return. While ranking proposed uses, it is also helpful to consider the risk associated with the proposed use.
One use might generate a much higher internal rate of return than all of the others. Yet, that high return may be related to the higher risk of that project. Adjust for the risk by applying a discount rate that is commensurate with the level of risk while computing the net present value. In the end, the use with the highest internal rate of return and net present value is the maximally productive use.
HIGHEST AND BEST USE FOR YOUR PROPERTY
Thank you for taking a glimpse into the highest and best use for your property. The determination of the highest and best use sometimes requires a more in-depth approach than a straight-forward valuation, where other elements may be overlooked.
Key items that my team and I focus on as full time real estate professionals are market trends, your properties physical and locational attributes, cost modifications versus existing use and proforma analysis. Simply stated we don’t put $1 of your money where we can’t get $3 or $10 back. We don’t throw darts at a wall and hope they stick. We have a calculated methodology behind each and every unique property and transaction that we enter into.
I’m David Clark, a Californian, real estate advisor REALTOR®, and writer for the Shelhamer Real Estate Group located in Northeast Los Angeles California, the fastest growing real estate market in Los Angeles County. Connect with me for further information about this article, and to add and optimize the value in your property.805.280.1425
Based on information from the / Association of REALTORS® (alternatively, from the /MLS) as of [date the AOR/MLS data was obtained]. All data, including all measurements and calculations of area, is obtained from various sources and has not been, and will not be, verified by broker or MLS. All information should be independently reviewed and verified for accuracy. Properties may or may not be listed by the office/agent presenting the information