Highest and Best Use – Optimizing Commercial Real Estate
April 30, 2019
Before professional appraisers can assign a market value to a property, they must perform two preliminary steps. First, they must gather and analyze the property market and marketability. Secondly, the appraiser determines the highest and best use by performing a highest and best use analysis. In this article, we’ll define and explore highest and best use. We will also illustrate the concept with a case study, provide tips and answer FAQs.
What Does “Highest and Best Use” Mean?
The Appraisal Institute uses this definition for highest and best use:
“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.”
Highest and best use analysis proceeds from the uses of land as if unused. However, it also accounts for existing land improvements, such as buildings, and possible changes to those improvements.
The appraiser will help you determine whether you should develop the land or leave it vacant. If left vacant, the appraiser should estimate when future development would be financially feasible. For land already developed, appraisers consider further improvements to optimize the property’s highest and best use. That is, the appraiser determines whether to keep, alter or demolish existing improvements. Furthermore, if the property warrants renovation or redevelopment, the appraiser should estimate when to build the new improvements.
For more information, read this comprehensive guide to commercial real estate appraisals. In addition, you can check out this complete guide to commercial remodeling and building renovation.
How to Perform a Highest and Best Use Analysis
If existing property, as improved, out-values the land as though vacant, then improvement is the highest and best use. The appraiser starts the highest and best use analysis by evaluating the land as though vacant. Then, the appraiser evaluates an improved property’s highest and best use via the property’s demolition, continuation or modification. The effort the appraiser expends analyzing the highest and best use of the land as though vacant varies. If the land truly is vacant, then the appraiser concentrates on highest and best use of the land. However, improvements outvaluing the raw land will shift focus to highest and best use analysis of the property as improved.
Highest and Best Use of “Land as if Vacant”
The definition of highest and best use of land as if vacant requires appraisers evaluate the following four criteria.
1. Legal Permissibility
Appraisers begin their highest and best use analysis reviewing building codes, zoning, private restrictions, environmental regulations and historic controls. Furthermore, they evaluate whether they can successfully appeal any restrictions in order to realize highest and best use. Certain private restrictions involving titles, deeds and long-term leases might impact building heights, setbacks and materials. Some local ordinances can increase costs without prohibiting use of the land. For example, a municipality might require an oversized water retention basin for a proposed shopping center. Historic controls can stop development right in its tracks, as can environmental regulations.
2. Physical Possibility
Appraisers evaluate land characteristics, including terrain, shape, size, frontage, depth, irregular shape, accessibility and risk of natural disasters. Obviously, land that is easier to access has higher utility. Naturally, views, or lack thereof, might affect certain types of properties (i.e., apartment buildings) but not others (i.e., factories). Clearly, requirements like grading or foundation construction can add costs, reducing the site’s competitiveness relative to nearby suitable sites. Other factors might include subsoil, topography, and proximity to sewers and utilities.
3. Financial Feasibility
Once a land parcel passes the legal and physical tests, appraisers next turn to financial feasibility. Generally, land use that delivers value in line with its costs is financially feasible. To that end, the appraiser uses data from the earlier market/marketability study to evaluate the property’s financial feasibility. Without enough demand for the property’s use, income will be insufficient for profitable results. Specifically, income must exceed the total of financial obligations, operating expenses and capital amortization.
Timing might be a factor, due in part to community changes. A retail property might be the highest and best use in several later, but apartments might provide better returns today. One can contemplate a mixed use facility that accommodates both uses. In other words, the developer could create the apartments now and postpone retail development until the time is ripe.
Appraisers can use the three valuation methods we describe in our article on commercial real estate appraisals. For income-producing alternatives, the appraiser estimates net operating income (NOI) for each use. From these estimates, the appraiser can identify which uses provide the best rates of return. To be financially feasible, the property must generate a positive rate of return. Appraisers must also evaluate risks, such as a specific use’s continued relevance.
4. Maximum Productivity
The appraiser has eliminated uses that fail any of the first three tests. Therefore, it’s time to identify the use with maximum productivity. First, for a use to be the highest and best use, it must be financially feasible. However, it should also provide the best rate of return, given the amount of risk. As described earlier, the appraiser can estimate both NOI and risk in order to figure the risk-adjusted rate of return.
Alternatively, the appraiser can adopt the cost approach to find the use that maximizes the land’s residual value. The use includes the land and improvements. This technique estimates the value of the use and then subtracts the costs. Specifically, costs include labor, capital and entrepreneurial effort.
A third approach is to investigate the going cost of land for various uses. For instance, apartment land might cost less than retail land. This is strong evidence that retail land is more valuable, as voted and ultimately determined by buyers’ dollars.
Appraisers can indicate the maximally productive use in general terms. For example, the highest and best use might be a commercial building or an office building. In some cases, market/marketability data may require a more specific recommendation. In other words, the appraiser might specify a 10-story office building or a 25,000-square-foot retail store.
Highest and Best Use of “Property as Improved”
Land with developed property requires a highest and best use analysis in light of existing improvements. The three possible outcomes are:
- Continue the Existing Use: The acquirer might simply buy the existing property and leave it as is. Alternatively, the acquirer can undertake renovation, rehabilitation or expansion of the property.
- Modify the Existing Use: The acquirer will adapt or convert the existing property to a new use. For example, developers can repurpose an old factory building as loft apartments.
- Demolish the Existing Improvements and Redevelop: The acquirer might decide to demolish an existing improvement and redevelop the site. For example, the buyer might acquire an abandoned apartment building and replace it with a hotel. To this end, you can read the articles Can I Buy an Apartment Building? and Multifamily For Sale: Complete Buyer’s Guide.
Highest and Best Use Case Study
Imagine a 100-year-old brick building in the central business district of a small city. The building currently serves as a retail space. The building is 15,000 square feet (SQFT), and its estimated value as vacant land is $150,000 ($10/SQFT). Some residents and businesses have relocated elsewhere over time. The building is 11% vacant and currently generates rent of $12/SQFT. The cost of operating the property is $34,000 annually and the NOI is $126,200. Professionally, the appraiser uses a 9% cap rate, yielding a property value of $1,402,222 (i.e., $126,200 / 0.09).
Alternatively, you could convert the property to an office building. Market and marketability research indicate the neighborhood is conducive to professionals, such as accountants, lawyers, designers, and architects. Interestingly, local office rent is $21/SQFT, and is increasing 2% per annum. Operating costs are about $5/SQFT on average and increasing by $0.25 per year.
Factually, redevelopment will cost $850,000 in Year-1, with an average vacancy of 75% during the renovations. Helpfully, vacancy will drop to 20% in Year-2 and then stabilize at a vacancy of only 5%. Of course, this equates to an occupancy rate of 95%, which is quite good. Resale after Year-5 earns $2,629,402, from dividing Year-6 NOI by the 9% cap rate. The net present value of all cash flows at a 10% discount rate is $1,485,848.
Based on this highest and best use analysis, the appraiser recommends converting the property to office space. This will maximize returns, as it produces additional value of ($1,485,848 — $1,402,222), or $83,626.
Tips for Highest and Best Use Analysis
We have formulated our best tips for the highest and best use as responses to four crucial questions. Appraisers and developers must be crystal clear on the answers to these questions to avoid costly mistakes. The four questions are:
- What can I do with the property? This requires that you understand not only zoning and other public restrictions relevant to a highest and best use analysis, but private restrictions as well. Private restrictions can take the form of deed or lease restrictions, and more.
- What is physically practical? Some uses of the property simply won’t work from a physical standpoint. For example, you likely can’t repurpose an old apartment building for heavy-duty manufacturing without having to demolish the old building first.
- Which uses are worth my time and money? In other words, how much money will you have to sink into the property to profit from improvement? Furthermore, will the return on improvement be the best use of your money?
- Which use maximizes my return? You should try to make your estimates as precise as possible. Moreover, you should put all estimates on an equal footing by taking the net present value of each use.
Finally, if you hit a roadblock that you can’t overcome, perhaps you should walk away from the deal. There might be better ways for you to invest your money.
Frequently Asked Questions: Highest and Best Use