The concept of highest and best use is one of the fundamental principles that underlie real estate appraisal. Highest and best use requires that the appraisal considers not just the current use of the property but also the potential value associated with alternative uses. The Appraisal Institute has four tests that appraisers can use in order to narrow down all of the alternatives to one highest and best use of the property.
Four Tests for Highest and Best Use
You can use the following four tests to find the highest and best use of a site as if vacant or currently improved.
- Is the use physically possible?
The first test of highest and best use simply evaluates whether it is possible to use the land in a certain way. Ignoring the zoning and economics of the proposal, consider whether or not the potential use is physically possible. That means the topography, soil type and conditions, lot size and shape, surface and subsurface water, and even weather patterns must make the development possible. So, you probably can’t build a marina in the middle of the desert, a heavy, marble building on soft clay soil, or a building with a 250,000 square foot base on a 200,000 square foot lot. In addition, an appraiser must not only consider the proposed use of the site but also the characteristics of the optimum improvements for that use. This first test, however, is usually the easiest to pass.
- Is the use legally permitted?
After eliminating any potential uses that are not physically possible, you can move on to the second test. Whether a potential use is legally permissible involves a few different legal considerations. The proposed use must be allowed by zoning 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. Concluding whether or not something is legally permissible is a straightforward process. Regulations, however, change over time. An area that was zoned for residential development can be changed to commercial development. Just because a proposed development is not legally permissible does not mean that it will always be that way. In these cases, an appraiser must consider the probability of the legal restriction being changed to allow the proposed development. In these cases, there should be substantial documentation suggesting that the regulation will be changed in order to pass to the third test of highest and best use.
- Would the use be financially feasible?
To address whether a proposed use is financially feasible, you need to conduct a market analysis and develop proforma cash flow estimates. You’ll need to collect data in order to forecast construction and development expenses, operating expenses, rents, absorption rates, vacancy rates, discount rates, cap rates, and residual values. Once you’ve gathered all of this information, you will 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. Only the proposed property uses that meet these criteria for being financially feasible move to the next step of the analysis.
- Would the use be maximally productive?
The prior steps eliminated proposed uses that were not physically possible, legally permissible, or financially feasible. This final 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. For example, one proposed use might generate a much higher internal rate of return than all of the other proposed uses. Yet, the reason for the high return may be related to the higher risk of that project. One way to adjust for the risk associated with a proposed use is to apply a discount rate that is commensurate with the level of risk while computing the net present value. In the end, the proposed use with the highest internal rate of return and net present value is the maximally productive use.
Applying Highest and Best Use to an Existing Structure
To illustrate how highest and best use works in practice, consider an old 1920s brick building in the central business district of a small city. Business and residents moved away from the area, and its current use as retail space may no longer be the highest and best use of the property. It is a 15,000 square foot building, and its estimated value as vacant land is $10/sqft, or $150,000.
In its current use as retail space, the property generates rent of $12/sqft. Vacancy rates are around 11% since foot traffic generally doesn’t support retail business in the area. Operating costs are $34,000 per year. Since conditions are fairly stable, capitalizing next year’s income at a rate of 9% yields an estimated property value of $1,402,222.
Another alternative would be to renovate the property and convert it into office space. Market research indicates this is a desirable area for professional office such as attorneys, accountants, architects, and designers. Market rent for offices in this area is $21 per square foot and has been increasing by 2% annually. Operating costs average $5/sqft and increase by $0.25 per year. Converting the property into office space will cost $850,000 in the first year, and average vacancy during the year will be 75% due to the time of the renovations. Vacancy is 20% in year 2 and then settles into a constant 5% thereafter. The resale price of $2,629,402 at the end of the 5-year holding period is calculated by dividing year 6 NOI by a 9% cap rate. The net present value of cash flows discounted at a rate of 10% yields a property value of $1,485,848.
Highest and best use analysis evaluates each potential use of the property and its corresponding value. The vacant property is valued at $150,000. Continuing to use the property for retail space yields an estimated value of $1,402,222. Converting the property into office space results in a value of $1,485,848. Highest and best use analysis, therefore, concludes that the best use of the property is as office space.
Conclusion
In this article, we discussed the 4 tests for highest and best use. These 4 tests ask if the proposed use is 1) physically possible, 2) legally permitted, 3) financially feasible, and 4) maximally productive. We then walked through an example of how to apply highest and best use theory to evaluate a property with three potential uses: as vacant land, as an existing structure, and as renovated.
The value of real property can be influenced by many factors, such as location and type of use; however, when appraisers make/render an opinion of market value, they must also take into consideration how typical buyers and sellers are responding in the market. Appraisers emulate what informed buyers and sellers will do in an open market. Therefore, we begin this lesson by first reviewing some of the basic concepts of real estate economics that affect how typically informed buyers and sellers respond in an open market, and then reviewing some concepts and principles applicable to the income approach. Based on observation and analysis of real estate markets, appraisers have developed principles to describe how real estate markets operate. These underlying appraisal principles are important in understanding the foundation of the income approach to value and the actions of typical buyers and sellers in the real property market. Although these principles are individually listed, many of the principles are interrelated or affect the other in determining real property value. This lesson discusses the following: The concept of highest and best use requires that each property be appraised as though it were being put to its most profitable use (highest possible present net worth), given probable legal, physical, and financial constraints. This entails identifying the most appropriate market and the most profitable use within that market. The highest and best use of a property is the reasonable and probable use that will support the highest present value as of the effective date of the appraisal. The use must be: Legally permissible: The highest and best use must be a use that is allowed by government. The property tax appraiser must consider the effect that any enforceable government restrictions, such as zoning regulations, have on the value of property.* However, an improved parcel with land uses that are not permitted under current regulations may have been constructed prior to current regulations. These improvements are recognized as legally (grandfathered) nonconforming uses. Physically possible: The highest and best use depends on physical factors. The proposed or existing use must fit the size, shape, topography, and other specific characteristics associated with the parcel or location. For example, a use that requires a larger site than the subject property, or needs utilities that are not available to the subject property, should be eliminated from consideration. Financially feasible: The highest and best use must not be too speculative. There must be a demand for the use in the market that will generate and sustain sufficient income to cover the costs of construction, to have enough money for maintenance during the economic life of the property, and to provide both a return of and a return on the investment. This can include costs to maintain or improve the remaining economic life. All uses that produce a positive return are regarded as financially feasible. Maximally productive: The highest and best use must be the most productive use. Of all the financially feasible uses, the one that produces the highest residual land value (yields the highest net return to the investor) is the highest and best use. For example, if it is physically possible, legally permissible, and financially feasible to construct an apartment complex, an office building, and a restaurant on a particular parcel, but the office building would yield the highest value to the real property, then the office building is considered the maximally productive use. In general, the proposed use that an appraiser determines would yield the highest and best use from a particular real property must pass all four criteria, or the proposed use (either the current use or an alternate use) cannot be considered the highest and best use of the real property. There are exceptions to this general rule. For example, if a parcel is currently improved with a dry cleaner, but zoning would allow an office building that could yield a higher value, the costs associated with cleaning up the property (remediating the property from any potential contaminates) would be cost prohibitive or cost so much as to leave the current or existing use as the highest and best use.
Concept of Highest and Best Use
Unless otherwise stipulated in the scope of work, when appraising an improved property, an appraiser will consider the highest and best use as it is improved and the highest and best use as if were vacant. Highest and Best Use as Improved addresses how an already improved property should be utilized. Highest and Best Use as if Vacant considers, among all reasonable, alternative uses, the use that yields the highest present land value. Any existing improvements can be torn down. In fact, demolition is economically appropriate when the market value of the land as if vacant exceeds the market value of the land as if improved.
A consequence of the concept of highest and best use is the Principle of Consistent Use – that, for an improved property, both the site and improvements must be evaluated as the same use. This principle is violated when the appraiser seeks to assign a value to the land based on one highest and best use, and a value to the improvements based on a different highest and best use. It is permissible, however, to consider time adjusted highest and best uses where neighborhoods are transitioning from one use to another, usually “higher”, use, recognizing the interim and ultimate highest and best uses.
Principle of Anticipation of Future Benefits
Property is valuable because of the future benefits it is expected (anticipated) to provide. A property's value may be defined as the present worth of the rights to all prospective future benefits, tangible and intangible, accruing to the ownership of real property. Therefore, investors buy income-producing properties today for the future benefits, or income, that is anticipated they will produce in the future.
One of the responsibilities of an appraiser is to interpret attitudes of persons trading in the real estate market. Thus, an appraiser is obligated to consider both the likelihood of future trends and the impact that such trends will have on buyers, sellers, and tenants, as expressed in present market transactions. For example, changes in anticipated demand caused by off-site improvements in the form of highways, freeways, bridges, schools, and parkways have an important impact on value even though such improvements may be in the planning stage and not visible at the time of the appraisal. Because the present value of real estate depends on expected future benefits, the principle of anticipation requires the appraiser to be fully informed of community affairs and economic changes anticipated in the market area in which the subject property is located.
It is the future, and not the past, with which an appraiser must be concerned. The history of operation of the subject, or like properties in a market area, is important only in ascertaining a trend in anticipated earnings over the remaining economic life or holding period of the property being appraised. Past operations and other than typical management practices may hinder or, in the case of accumulated goodwill, accelerate (at least for a time) income production. Such assets or liabilities of a property must be considered in the measure of present value. For property tax purposes, we are required to measure the full value of the property; that includes good management, maintenance, and typical interaction with the market place.
Principle of Substitution
The principle of substitution states that the upper limit of value tends to be set by the cost of acquiring an equally desirable substitute, assuming no untimely delays. A prudent investor would pay no more for an income-producing property than it would cost to build or purchase a similar property. Likewise, a prudent lessee would not pay more rent than they would pay to rent an equally desirable property.
When several commodities or services with substantially the same utility or benefit are available, the one with the lowest price attracts the greatest demand and widest distribution. In the income approach, value tends to be set by the cost necessary to purchase a property offering an equally desirable income stream. This theory provides the basis for using comparable properties in the income approach to value.
From The Appraisal of Real Estate, the prices, rents, and rates of return of a property tend to be set by the prevailing prices, rents, and rates of return for equally desirable substitute properties. The principle of substitution is found in each of the three approaches (income, comparative sales, and cost) to value.
All properties, no matter how diverse their physical attributes or how varied in geographic location, are substitutable economically in terms of service utility or in income productivity, provided such can be fashioned without undue (costly) delay. When there is a significant delay in acquiring the substitute, the cost of the delay must be taken into consideration; a significant delay, in effect, raises the cost. The principle of substitution is closely related to the economic concept of opportunity cost, which holds that the true cost of an economic choice is measured by the opportunity foregone because of the choice.
Principle of Supply and Demand
Interaction between the supply of goods and the demand for goods establishes both the price and the quantity of goods demanded. Demand, the amount of a good or service that would be purchased at various prices during a given period, is created by a product’s utility and the ability and willingness of people to buy it. Buyers and sellers tend to set the price or value of a good based on the supply of a good and the demand for that good. If the supply of a good is stable, and demand for that good increases, sellers of that good tend to increase the price. Supply in the real estate market takes a long time to create; therefore, if the demand for real estate increases, the price of the real estate will also increase, because the supply of real estate will be slow to adjust.
Principle of Changes in Socioeconomic Patterns
Nothing is static; change is constantly occurring. The principle of change recognizes the dynamic nature of real estate markets. In real estate, change affects not only individual properties, but also neighborhoods, communities, and regions. The effects of prospective change are reflected in the market. Change is fundamentally the law of cause and effect. Individual properties, districts, neighborhoods and entire communities often follow a four phase life span:
- Growth: a period during which the area gains in public favor or acceptance.
- Stability: a period of equilibrium without significant gains or losses.
- Decline: a period of diminishing demand and acceptance.
- Renewal: a period of rejuvenation and rebirth of market demand.
The principle of change is closely related to the principle of anticipation. Past income experiences may indicate a certain trend, and present income flow may substantiate this trend; nevertheless, the anticipated future income expectancy may radically differ because of important changes in national, regional, and local business activity of which the real estate market is a part.
Principle of Conformity
The principle of conformity states that maximum value is realized when a reasonable degree of architectural homogeneity exists and land uses are compatible. This principle implies reasonable similarity, not monotonous uniformity, tends to create and maintain value. The highest and best land use is generally realized under circumstances of conformity or harmony. The principal purpose of zoning regulations and private deed restrictions is to maintain conformity.
Principle of Contribution, AKA Principle of Marginal Productivity
The principle of contribution, also known as the principle of marginal productivity, applies the principle of increasing and decreasing returns to property components. This principle holds that the value of a property component is measured in terms of its contribution to the value of the total property rather than as a separate component. Note that the cost of an item does not necessarily equal its contributory value. For instance, it may cost $30,000 to build a pool in a 20 unit apartment complex; however, it may only add $20,000 to the overall value of the complex.
Principle of Increasing and Decreasing Returns
The principle of increasing and decreasing returns recognizes that increments of the agents of production produce greater net income (increasing returns) up to a point (surplus productivity). The point of maximum contribution of the agents in production (point of decreasing returns) attests to the proper combination of agents, resulting in the highest and best use. Any further increase in the amount of the agents of production will decrease the margin between the cost of agents and the gross income they will produce, resulting in a decrease in the proportionate net income returns.
Increasing and decreasing returns applies to the maximum size apartment building that should be placed on a parcel of land. Adding stories to an apartment building may result in property value exceeding costs until the point is reached that the structures must be framed with steel on top of foundation piles driven down to the bedrock. At this point, the added cost, over wood framing on top of a concrete podium, may not result in added value commensurate with the cost – this would be the point of decreasing returns.
A decreasing, or diminishing, return is the proportional decrease in the amount of return as a single element of production is increased, all other factors remaining constant. This Law of Decreasing Returns is also known as the Law of Variable Proportions.
Principle of Balance in Land Use and Development
The principle of balance is closely related to the principle of increasing and decreasing returns; it holds that maximum value is achieved and maintained when all elements in the agents of production are in economic balance. The value of a property depends on the balance of:
- Land
- Labor
- Capital
- Entrepreneurship
Land includes the ground, the airspace, and the natural resources found on the surface or in the sub-surface of the earth. Labor includes human work directed toward production—that is, all wages and other operating expenses involving human work. Capital is composed of goods (e.g., equipment and buildings) and intangible assets and rights (e.g., working capital and franchises) used in the production process. Unlike other factors of production, capital must be produced before it can be utilized in the production process. Human capital is the productive power of individuals developed through education and training. Entrepreneurship is the act of visualizing needs and taking the necessary action and risk to produce products that fulfill such needs. In real estate development, entrepreneurship is synonymous with the development function.
Elements both internal and external to a property must be in balance for maximum value to be attained. Internally, the proper combination of land and building is critical to economic balance. Externally, a property should be in balance with surrounding properties. For example, an expensive home built on a low-value lot in a modest neighborhood may not sell for its full cost of production.
Summary
Note: Before proceeding on to the next lesson, be sure to complete the exercises for this lesson.