Developers, investors, city planners, neighborhood committees, families of owners, and other interested parties usually have clashing opinions about what’s best for a given piece of property, but the system that assigns a dollar value is that of "highest and best use" (HBU). This process evaluates the property against several benchmarks, with profitability as the key metric. Highest and best use is helpful in understanding what sort of capital improvements or renovations a property may need, and it may not align with other factors like historical significance or social impact. On the other hand, it might. It’s not a perfect system, but as far as filtering out all the plans that don’t make sense from a fiscal, legal, or physical standpoint, it’s effective market analysis.
The definition of highest and best use for real estate
Highest and best use is defined as the most financially productive usage of a property. It takes into consideration not just the existing structure and use, but also the potential value that could be associated with alternative uses. There are several parameters, buyer assessments, and market analyses that determine a property’s highest and best use.
Who/what determines highest and best use?
Appraisers are the real estate professionals who determine highest and best use for individual pieces of real estate. What they are evaluating, according to the Appraisal Institute, is:
"The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible, and that results in the highest value."
They use four different tests to evaluate this. Each is focused on one of the specific benchmarks for HBU. These are:
1. What uses are physically possible?
It doesn’t matter how lofty someone’s ambitions for a property are if the land itself cannot support the plans. Thus, the first test looks at geological factors such as:
- What is the lot size and shape?
- What is the subsurface water like?
- Topography of the land.
- Weather patterns in that exact area.
2. Is the use legally permitted?
This doesn’t consider legal versus illegal activities, but instead looks at :
3. Would the use be financially feasible?
This is where intense market analysis comes into play. The appraiser looks at:
- Net operating income projections.
- Cash flow estimates.
- Income tax and inflation projections.
- If the goal is eventual resale, is the proposed buyer’s renovation and resale plan realistic?
4. Would the proposed use be maximally productive?
This evaluates not from an activity standpoint but from a risk assessment one. Factors considered include:
- What are the motivations of the person making an offer?
- Does the would-be buyer have the financial resources to not only complete this transaction but also to support their plans?
- What would the proposed improvements to the property contribute to the community?
- Anticipation of future benefits based on future developments or trends in the community (i.e., highway improvements, new community spaces, commercial developments underway).
- What is the highest internal rate of return (IRR) that can be attained for a reasonable amount of risk?
When evaluating the potential a parcel holds, an appraiser does not consider emotional attachments to a structure or emotion-driven unrealistic expectations about what potential a parcel holds. Quite the opposite, the appraisal process uses facts and equations to create a funnel process, whereby many potential uses are filtered down to just the feasible ones. They do an analysis of market forces; they consider factors like easements and eminent domain; and they look at all possible uses. They also consider land value and market participants.
While some people feel that an appraisal of potential value on a nonexistent structure is subjective, appraisers try to evaluate against existing data as much as possible. To do this, they use one of three different approaches.
1. The sales comparison approach
What have comparable properties in the same neighborhood sold for recently? What features of the property (i.e., amenities, lot size) make it worth less or more than the comparable properties, and would proposed improvements increase its potential to reach maximum profitability?
2. The cost approach
How much it would cost to rebuild the property, less the accrued depreciation. This is often used for public properties like schools and libraries, because these structures don’t achieve maximum profitability from a purely financial standpoint, but they are vital to the community.
3. The income approach
Looks at income derived from a property for its owner and whether there is potential to increase it.
How can other buildings impact a property’s potential highest and best use?
In many ways, similar buildings or neighboring buildings have the most power to impact a property’s appraisal of highest and best use. If an appraiser is using the sales comparison approach, they’re using other similar properties to measure the potential of the one they’re appraising. If they’re using the income approach, they're looking at how much income an existing property generates and comparing it with market value in the neighborhood. This means a potential buyer can't enter into serious negotiations to buy a piece of real property without studying the other buildings in the neighborhood.
This even goes for if you’re fixing and flipping houses, or attempting to buy a duplex and rent out half as an income property. Even these relatively small-scale transactions will be subject to an appraisal report before the bank loans money. Also, potential buyers can get information with ease these days from tools like Redfin, which always lists three recent sales of similar homes in the neighborhood on the same page as a listed property, so anyone looking can see what the market value is.
What real estate terms are connected to highest and best use?
Various economic theory concepts play into the determination of highest and best use for real estate.
This is sometimes the benchmark for Test #4 instead of “productivity.” How is the property currently or potentially useful for owners, tenants, and the neighborhood? Could it become more useful? More profitable?
How much would it cost to buy a completely comparable property -- that is, one that provides the same utility at the same quality? This sets the upper limit of value but also puts some parameters around how long a developer or investor should reasonably chase after just one specific piece of property if there are multiple equally desirable substitutes in the vicinity.
What are proposed improvements contributing to the highest and best use of a property? In many cases, buyers may want to renovate a building or repurpose it in a way that doesn’t take it toward highest and best use , in which case no matter how expensive or interesting their proposed improvements are, they aren’t actually contributions.
How important is an HBU document for determining a property’s value?
It’s an integral part of the process. Imperfect though it may be, it provides a detailed assessment of the hyper-local market where the property sits as well as various analyses of feasibility from all sorts of perspectives.