Highest and best use

What Is Highest and Best Use?

Highest and best use is a fundamental concept in real estate appraisal that identifies the most probable and legally permissible use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. This principle is a cornerstone within the broader field of real estate appraisal, guiding professionals in determining a property's optimal utility and its corresponding contribution to market value. It emphasizes evaluating a property not just by its current use, but by its maximum potential to generate value. The determination of highest and best use is crucial for various investment decisions and informs accurate property valuations.

History and Origin

The concept of highest and best use can be traced back to early economic principles and the study of land economics, with economists such as Irving Fisher conceptualizing the idea of maximum productivity from land. Initially, appraisal practices in the early 20th century primarily focused on the cost approach to valuation. However, the recognition that a property's value is derived from its future usefulness, rather than just its historical cost or current price, spurred the evolution of appraisal theory.¹⁷

The formalization of "highest and best use" as a core appraisal principle gained prominence to address valuation challenges in real estate, particularly in situations like condemnation proceedings where fair compensation for property was required.¹⁶,¹⁵ Over time, professional appraisal organizations, such as The Appraisal Institute, have refined and standardized the definition and application of highest and best use.¹⁴,¹³ The Uniform Standards of Professional Appraisal Practice (USPAP), which govern appraisal analysis and reports in the United States, also mandates that appraisers analyze relevant factors to support their highest and best use conclusions when forming a market value opinion.¹²,

Key Takeaways

• Highest and best use identifies the most profitable, legal, and physically possible use of a property.
• It is a core principle in real estate appraisal, guiding the determination of a property's market value.
• The analysis considers four key criteria: legal permissibility, physical possibility, financial feasibility, and maximum productivity.
• A property's current use may not always represent its highest and best use.
• The concept is vital for informed real estate investment, development, and financing decisions.

Formula and Calculation

Highest and best use itself does not have a single mathematical formula. Instead, it is a qualitative and quantitative analytical process that culminates in identifying the use that yields the highest return or value. The determination involves evaluating potential uses against four criteria. For each potential use that satisfies the legal and physical criteria, a financial analysis is performed. This often involves calculating metrics such as net present value (NPV) or internal rate of return (IRR) to compare profitability.

For example, if evaluating multiple proposed uses for a vacant parcel of land, an appraiser might project the cash flow generated by each use and then discount those future cash flows to a present value. The use resulting in the highest present value would typically be considered the maximally productive and, therefore, the highest and best use.

Where:

• (CF_t) = Net cash flow during period (t)
• (r) = Discount rate (reflecting risk analysis)
• (C_0) = Initial capital expenditure
• (n) = Number of periods

Interpreting the Highest and Best Use

Interpreting the highest and best use involves understanding that it represents the optimal utilization of a property, not necessarily its current state. The analysis provides a conclusion about the "highest value" use, which often translates to the greatest economic return. This interpretation is dynamic; market conditions, regulatory changes, and physical possibilities can shift over time, leading to a change in a property's highest and best use.¹¹,¹⁰

For improved properties, the analysis considers two scenarios: the property as if vacant and available for development, and the property as currently improved. The appraiser determines which of these scenarios, and which specific use within them, generates the highest value. If the value of the vacant land (minus demolition costs) is greater than the value of the property as improved, it suggests that demolition and redevelopment might represent the highest and best use.⁹ Conversely, if the existing improvements generate a greater value than any alternative use of the vacant land, then maintaining or enhancing the current improvements would be deemed the highest and best use.

Hypothetical Example

Consider a one-acre parcel of land located on the outskirts of a growing city. It is currently zoned for residential use, permitting the construction of single-family homes. However, a new highway exit has recently opened nearby, increasing accessibility. An investor is considering purchasing the land and wants to determine its highest and best use.

1. Legally Permissible: The land is currently zoned for residential use. However, the investor investigates the possibility of obtaining a zoning change to commercial use due to the new highway access. Assume both residential and commercial uses are considered potentially permissible (either currently or with a probable zoning change).
2. Physically Possible: The land is flat, has access to utilities, and is of sufficient size for either residential development (e.g., 5-7 homes) or a commercial retail center.
3. Financial Feasibility:
   • Residential Use: Building 6 single-family homes. Estimated development costs are $1,500,000. Expected sales revenue is $2,400,000, leading to a projected profit of $900,000.
   • Commercial Use (Retail Center): Building a small retail strip mall. Estimated development costs (including potential rezoning costs) are $3,000,000. Expected annual net operating income is $300,000. Using a capitalization rate of 7%, the estimated value as a retail center is $4,285,714 ($300,000 / 0.07), leading to a projected profit of $1,285,714.
4. Maximally Productive: Comparing the projected profits, the commercial retail center offers a higher potential return of $1,285,714 compared to $900,000 for residential development.

In this hypothetical scenario, even though the current zoning is residential, the highest and best use analysis suggests that the land's most productive use, assuming a probable zoning change, would be a commercial retail center due to its greater financial feasibility and highest potential value.

Practical Applications

The concept of highest and best use is applied across various aspects of finance and real estate, serving as a critical analytical tool.

• Real Estate Development: Developers utilize highest and best use analysis to identify the most profitable type of project for a specific parcel of land, whether it's residential, commercial, industrial, or mixed-use. This guides decisions on land acquisition, design, and construction, ensuring resources are allocated to maximize value.
• Property Valuation and Appraisal: Appraisers are required to consider the highest and best use of a property when determining its market value. This is a foundational step in the appraisal process for various purposes, including sales, financing, taxation, and legal proceedings. The Appraisal Institute emphasizes this as a cornerstone in real estate valuation.⁸
• Investment and Portfolio Management: Investors use this analysis to evaluate potential acquisitions, compare alternative valuation methods for properties, and make informed choices about diversifying their real estate portfolios. Understanding a property's highest and best use can highlight untapped potential or undervalued assets.
• Lending and Underwriting: Financial institutions rely on highest and best use conclusions when underwriting loans secured by real estate, particularly for construction loans or redevelopment projects. It helps assess the long-term viability and collateral value of the property.
• Urban Planning and Land Use Policy: Local governments and planners consider the principles of highest and best use to inform zoning ordinances, infrastructure development, and master plans. This helps ensure that land resources are utilized efficiently to benefit the community and support economic growth, especially in response to evolving market conditions.⁷ For example, shifting economic landscapes or demographic changes can significantly impact commercial real estate markets, influencing what constitutes a property's highest and best use.⁶, [FRBSF]

Limitations and Criticisms

While a fundamental principle in real estate appraisal, highest and best use has certain limitations and has faced criticisms. One primary challenge is the subjective nature of forecasting future market conditions and demand, which are crucial for determining financial feasibility. Appraisers must make assumptions about future supply and demand trends, which introduces a degree of uncertainty.⁵

Another limitation arises when two qualified appraisers, analyzing the same property, arrive at different conclusions regarding its highest and best use due to varying interpretations of market data or assumptions about what is "reasonably probable."⁴ This can lead to discrepancies in valuation outcomes. Furthermore, the analysis may be complex for improved properties where the existing structure may or may not align with the highest and best use of the vacant land, requiring a nuanced assessment of demolition costs versus renovation benefits.³

The concept also implicitly assumes a rational market and unconstrained property rights, which may not always hold true in reality. External factors like unforeseen economic downturns, changes in environmental regulations, or community opposition to certain developments can alter a property's potential. Some critics also argue that an overemphasis on maximizing financial returns might sometimes overlook broader societal or environmental considerations.

Highest and Best Use vs. Market Value

Highest and best use and market value are closely related but distinct concepts in real estate.

While highest and best use is a critical step in determining market value, it is not the market value itself. Rather, market value is the price that a property is estimated to achieve when put to its highest and best use. Confusion often arises because appraisers aim to establish market value based on this optimal use, even if the property is currently underutilized.

FAQs

What are the "four tests" of highest and best use?

The four tests for determining highest and best use are:

1. Legally Permissible: Is the proposed use allowed by zoning laws, building codes, and other regulations?
2. Physically Possible: Can the property physically accommodate the proposed use, considering its size, shape, topography, and access?
3. Financially Feasible: Will the proposed use generate a positive return and justify the necessary investment, demonstrating financial feasibility?
4. Maximally Productive: Among all uses that pass the first three tests, which one will produce the highest overall value or net return for the property?,²,¹

Does highest and best use always mean the current use of a property?

No, highest and best use does not always mean the current use of a property. An appraiser must consider both the property as currently improved and as if vacant. If an alternative use could generate a significantly higher value, even if it requires demolition or extensive renovation, that alternative could be considered the highest and best use.

Why is highest and best use important in real estate appraisal?

Highest and best use is important because it provides a foundation for developing a credible opinion of market value. By identifying the most optimal use, appraisers can select appropriate comparable sales and valuation methods, ensuring that the appraised value reflects the property's full potential in the market, rather than just its existing, potentially suboptimal, use. This analysis also helps inform critical investment decisions for buyers, sellers, and lenders.