Highest and best use

Highest and best use is a concept in real estate appraisal. It states that the valueof a property is directly related to the use of that property; the highest and best use is the reasonably probable use that produces the highest property value. This use, the Highest and Best Use, may or may not be the current use of the property.

Test of highest and best use

In order to be considered as the Highest and Best Use of a property, any potential use must pass as series of tests. The exact definition of Highest and Best Use varies, but generally the use must be:

* legally allowable
* physically possible
* financially feasible
* maximally productive

Legally allowable

Only those uses that are, or may be, legally allowed are potential highest and best uses. This may exclude uses that are not, and unlikely to become, allowed by zoning, uses forbidden by government regulations, and uses prohibited by deed restrictions or covenants.

Properties with a use that predates existing zoning regulations may be "legally nonconforming". Such "grandfathered uses" are generally legal even though they do not meet current zoning regulations. Since their use predates the zoning, they are "grandfathered in". However, some such uses may not be reproduced if the legally nonconforming improvement is destroyed or damaged beyond a certain point.

Physically possible

Any potential use must be physically possible given the size, shape, topography, and other characteristics of the site. For example a 40,000 square foot single story warehouse would not fit on a 10,000 square foot site, therefore that use would fail the physical possibility test.

Financial feasibility

The highest and best use of a property must be financially feasible. This means that the proposed use of a property must generate adequate revenue to justify the costs of construction plus a profit for the developer. In the case of an improved property, with obvious remaining economic life, the question of financial feasibility is somewhat irrelevant. In the case of an improved property with limited remaining economic life, the question of financial feasibility becomes a question of the maximally productive use of the site. If the value of the land As Vacant exceeds the value of the property As Improved, then redevelopment of the site becomes the maximally productive use of the property and continued use of the existing improvements that do not represent the highest net value of the site is considered to be financially unfeasible.

Maximally productive use

Finally the use must generate the highest net return (profit) to the developer. A property that could hypothetically be developed with residential, commercial or industrial development might only have one of those uses as its highest and best use. These three hypothetical development scenarios follow to illustrate the test of maximally productive use.

Price of Site: $100,000 (remains unchanged in all three examples)

_____

Cost to construct 10,000 SF industrial warehouse: $750,000

Market Value of 10,000 SF industrial warehouse: $910,000

Profit for industrial development: 7%

_____

Cost to construct 10,000 SF retail strip center: $1,500,000

Market Value of 10,000 SF retail strip center: $1,840,000

Profit for retail development: 15%

_____

Cost to construct 10,000 SF of residential condominiums: $1,200,000

Market Value of 10,000 SF of residential condominiums: $1,534,000

Profit for residential development: 18%

_____

As the examples illustrate, even though the retail development results in the overall highest market value for the development, the residential development scenario results in the highest net return to the developer and this makes it the maximally productive use.

Vacant and improved

The Test of Highest and Best Use is applied to an improved properties both "as improved" and "as if vacant". Vacant properties are generally only given the "as vacant" test. The Highest and Best Use as vacant may be the same or different as the Highest and Best use as improved.

For example, "House A" in a residentially zoned area may have a highest and best use as vacant and a highest and best use as improved that are both residential. A similar "House B" in a commercially zoned area may have a highest and best use as vacant as a commercial lot and "highest and best use as improved" as a single family residence.

If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the "as vacant" value of the commercial lot. For example, assume that "House B" has a value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to demolish the house and prepare the site at $25,000. The Highest and Best Use of the site is to demolish the house and sell the site as a commercial lot. The market value would be $225,000 ($250,000 site value minus $25,000 demolition cost). However if the demolition costs rose to $55,000, the Highest and Best Use would be the existing residential use, because the value as a commercial lot (now $195,000) would not exceed the existing value as a residence.

This would be the Highest and Best Use of the property, even though it is contrary towhat actually exists. Even if the house is not razed and the site sold as a commerciallot, the Highest and Best Use is the commercial lot use. The market value of theproperty is driven by this hypothetical conversion, even if it never takes place due to theutility that this potential conversion would bring to a purchaser.

Economic theory

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 potentialpurchaser. The purchaser of such a property would pay no more than a competing property with the same utility while a seller would accept no less that a seller of a comparable property. That is true to the neighbourhood.

References

*The Appraisal of Real Estate, 12th Edition, by the Appraisal Institute