When appraising real estate, appraisers are trained to determine a property’s market value according to its “highest and best use,” regardless of how the property is actually being used at the time of valuation. The historical reason appraisers consider highest and best use (HBU) when performing a valuation ties back to the 19th and early 20th-century real estate concept of maximum productivity.
This concept is still very much in play in today’s real estate market. But how does an appraiser determine the highest and best use of a piece of land? This article will explore the philosophy and practical application behind the highest and best use in real estate valuations.
How to Determine Highest and Best Use
Appraisers have certain constraints when determining the highest and best use of a property. These constraints—sometimes referred to as tests—are practical, legal, and financial in scope.
A property is tested against these constraints to determine what maximum productivity is actually practical—i.e., compliant with the law, affordable, and physically doable considering the land itself.
There are generally four tests appraisers will use to determine the highest and best use of property:
- legally permissible
- physically possible
- financially feasible
- maximally productive
The highest and best use of land must be legally permissible. This means appraisers must work within the existing legal framework when considering the HBU. Certain legal considerations include:
- Zoning laws
- Local ordinances
- Environmental protections
- Regulatory laws
However, what is legally permissible at the moment might not preclude future legal permissibility. For example, if a property isn’t zoned for commercial use, an appraiser can still consider it for commercial use if there is a greater than 50% chance the property would be approved for commercial use.
Appraisers can creatively work within the legal restrictions on property to reach an HBU.
Appraisers are also constrained by what is physically possible on the property. One property’s environmental and topographical characteristics will vary considerably from another property with the same square footage.
A 10,000 sq. ft. facility might fit well on one 20,000 sq. ft. property but won’t fit feasibly on a comparable property for various reasons. Perhaps one property is marshy or sandy or contains hazardous waste. These restrictions will affect the highest and best use of that property.
The highest and best use of a property must also be financially feasible. In other words, the projected use of a property must generate enough profit to justify the development of the property.
If the costs of repurposing property exceed the projected revenue of the property, then that particular use of the property is not financially feasible. As a result, that particular use is not the highest and best use by default.
The use of a property is maximally productive when it generates the highest return for its developers. One property could have several potential uses, but only one option will generate the highest profit for developers.
For example, let’s say developers just purchased a 10,000-square-foot plot of vacant land for $100,000. They have several options for generating profit with this land, but only one option will produce the highest returns.
Option 1: Commercial Warehouse Space
Let’s say that the cost to develop this space into a commercial warehouse would be $600,000, and the market value upon completion is $800,000. When the purchase price of the vacant plot is considered, the return is only $100,000.
Option 2: Commercial Retail Strip Mall
Let’s say the cost to develop this space into a retail strip mall would be $1,000,000, and the market value of this particular use of the property is determined to be $1,500,000. Here, the return is $500,000.
Option 3: Luxury Apartments
Let’s say the cost to develop this property into luxury apartments is $1,500,000, and the market value of the completed project is $2,500,000. Here the return is $1,000,000.
The maximally productive option might first appear to be option 3, as it nets a return of $1,000,000. However, the initial cost to develop this property is $1,500,000. Whether or not option 3 is actually the maximally productive option depends on the initial capital investment of the developers. This option might not be financially feasible for some developers.
Whether or not the use of a property is maximally productive is contingent upon the other constraints, too, like its financial feasibility and legal permissibility.
Understanding Highest and Best Use
According to Roni Davis from First National Realty Partners, a commercial real estate investing company, “Calculating the highest and best use of a property is more complicated than it appears on the surface. Not only do the physical limitations of the property factor into the valuation, but the financial limitations of the developers, as well as legal restrictions ultimately determine the highest and best use of a property.”