Highest & Best Use
Appraisers love to think of real estate in terms of Highest and Best Use, which is defined in The Appraisal of Real Estate, 14th Edition as “the reasonably probable use of property that results in the highest value.” Determining a Highest and Best use for a property is an essential and required step in the appraiser’s process of estimating market value. At its most basic level, highest and best use analysis is simply a formalized and orderly process for thinking about what a property could be, might be, should be, or will be now or in the future. To get from the extremely lengthy list of possible uses for a vacant piece of land (single family house, restaurant, high-rise office building, fertilizer plant, cathedral, amusement park, airport, etc.) to the Highest and Best Use for a property, the appraiser uses the following four questions:
1. Is the use legally permissible? Think zoning regulations, building codes, easements, covenants, and/or deed restrictions on the land. While you might think that you’ve got a perfect site for a gas station on a high-traffic corner, if zoning does not allow that use, it does not meet the legally permissible test. However, owners often challenge this through rezoning and special use permit requests to allow for their proposed use. Many large acreage tracts go from farmland and forest to high-density subdivisions by this path. The cost and likelihood of rezoning will vary greatly depending on the specific property, the proposed use, and the locality.
2. Is the use physically possible? Think topography, site size, and shape. A typical fast food restaurant would need about one acre to accommodate the building footprint, parking, and meet zoning requirements. Most end-users have specific site requirements that detail their ideal site size and dimensions, access (some users demand stoplights, while others can live with a right turn-in/right turn-out), proximity to their existing locations as well as competitors, and many other factors that can and do evolve over time.
A big story in commercial real estate right now is the potential impact of newly implemented state storm water regulations on site development and construction costs, which, in turn, could impact site selection and project feasibility. Definitive answers to the “What is physically possible?” question would typically come from land surveying, site planning, and civil engineering companies, such as Berkley Howell, Perkins & Orrison, WW Associates, Wiley|Wilson, and Hurt & Proffitt.
3. Is the use financially feasible? To make the short list for Highest and Best Use, a potential use has to make financial sense. Users study market demand, demographics, competitive properties, and other factors to estimate whether a project will be feasible. For example, you may have a great site for a light warehouse in an industrial park, but if there is high vacancy and an oversupply of warehouse properties in your market, construction of the proposed structure is likely not financially feasible at the current time.
These three knockout rounds should get the list of possible uses to a much more manageable level. The final question is:
4. Of the uses that meet those three tests, which use is maximally productive or results in the highest value? In a simplified example, if a triplex and office building both meet all three tests, but land prices for triplex development indicate a price of $100,000 per acre while office dirt is going for $250,000 per acre, then office use would be maximally productive and the highest and best use of the land.
A Highest and Best Use discussion is not just for vacant land as appraisers use the same process when considering improved properties as well. The Highest and Best Use conclusion for an improved property might be for the existing improvements to remain exactly as currently built, to be altered or renovated, or even to be demolished to create a vacant site.
Let’s say you inherited a 1950s vintage brick rancher on a 1-acre site with a commercial zoning and 200 feet of frontage on Wards Road sandwiched between two fast food restaurants. You would intuitively know that the current use, as a single family residence, is not the highest and best use of the site and that eventually this house will be torn down. In fact, you’ve been approached by a local commercial real estate broker with a purchase offer from a national retailer. While the owner would probably look at this site as a winning lottery ticket to be cashed in at the right time, the appraiser would take this information to mean that they should compare this property to sales of commercial development sites rather than sales of similar single family houses that do not have a commercial zoning or favorable location. The last question left for the owner would be, “Do you sell now and take the money or keep waiting for a few years to see if the price goes even higher?”
This leads us to the final consideration of Highest and Best Use: Timing. You may believe that a certain corridor is “going commercial” (think 221 in Forest), but you might also think your property is not quite there yet and choose to hold tight. Immediate development or redevelopment is not always the highest and best use. If improved, the highest and best use may be to continue with the current interim use. If vacant, it is perfectly legitimate to conclude that the highest and best use for that vacant site is, in fact, to hold for future development or “wait for the market to catch up.”
Just as the buy-sell decisions can be agonizing for the owners and users involved, Highest and Best Use is not often quite so obvious and typically the principal challenge of an appraisal assignment. While the Highest and Best Use conclusion, even the value itself, are ultimately just the appraiser’s opinion, hopefully this opinion is informed and well-supported by market evidence. If so, the Highest and Best Use analysis can be an extremely useful tool for guiding the appraiser’s valuation and improving the thinking of all market participants.
By William A. Hansen, IV, MAI