Depending on who you ask, a particular property might have many different optimal uses. For a given empty lot, a city planner might envision a neighborhood park, while a developer might prefer an apartment building, and local parents might imagine a new elementary school.
One method of determining the best way to use a property is a system called “highest and best use.” Highest and best use is a real estate term for the most profitable possible use of a property. It does not take into account social or historical value, or non-financial benefits like open space. Nonetheless, it remains one useful way of deciding how to use a property.
Here’s everything you need to know about highest and best use in real estate.
What Is Highest & Best Use In Real Estate?
Highest and best use is the most profitable use of a given property. Calculating the highest and best use requires you to know the property’s current use and the profitability of other possible uses. As you might imagine, this requires a lot of analysis and assessment, and it can take some time to get exact numbers.
Highest and best use also includes any costs that would be incurred in switching from one use to another. For example, converting a block of single-family homes to a multi-family apartment complex incurs construction costs, which factor into the equation. If construction costs are high enough, the highest and best use might still be for single-family homes.
In other cases, the highest and best use is limited to a particular type of use. This is often the case with parkland, where a city has mandated that the area is to remain public space. In that situation, an appraiser might recommend a skate park, a playground, or a dog walk, but they won’t recommend a fast food restaurant.
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What Are The 4 Tests Of Highest & Best Use?
There are four standards a use must meet in order to bee highest and best. It must be:
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Physically possible
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Legally permissible
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Financially feasible
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Maximally productive
Let’s take a closer look at all four.
1. Uses That Are Physically Possible
To begin with, a site needs to be physically large enough for the application. For example, suppose you want to install a 60,000-square foot big box store. If the property only has a footprint of 20,000 square feet, you won’t have enough space to put the store.
The terrain is another important consideration. Perhaps the site is large enough for your application, but it’s on an extreme incline. In that case, you might want to consider a different application, or dividing the site into multiple plots.
Accessibility is an extremely important factor. Think about how people are going to get to and from your property. For example, you wouldn’t want to build a sports arena on a one-way street with no parking.
The concept of physical possibility can also be used to assess a current property. A good example of this is a large property with a single small structure and a huge parking lot. In this case, the property is being under-utilized, and is not being put to its highest and best use.
2. Legally Permitted Uses
In most cases, the legally permitted use is determined by your local government’s zoning rules. Most properties have specific requirements regarding application, density, and other property features. There will also be minimum and maximum lot and building sizes.
Along the same lines, some properties come with deed restrictions. There may be easements for utilities, or, in the case of waterfront properties, a maintenance easement. This can limit what you’re able to build on the property, or what purposes it can be used for. For these reasons, a boundary survey is an important part of the assessment process.
In some cases, the current use may be “grandfathered.” This means that it was legal when the property was first put to that use, but that regulations have since changed. At this point, the current use is still legal, but if the property is re-developed, it must be repurposed. For example, there might be a small shop in an area that’s now zoned as residential. If you were to buy the building and renovate it, it would no longer be grandfathered, so it could no longer be used for commercial purposes.
3. Financial Feasibility
Financial feasible means whether any investments would be realistic or wasteful. You wouldn’t build an airport when your city already has one that meets all of its needs, for example. You also wouldn’t build a giant high-rise apartment building in a small city with low housing demand.
Financial feasibility often comes into play in the world of residential real estate. When a house is rebuilt or renovated, it’s important to build it to a similar standard as the rest of the homes in the neighborhood. For example, imagine a neighborhood that’s made up of smaller, more modest homes.
Building a bigger home with more amenities isn’t likely to be a good investment, because anyone looking for that kind of home will want to live in a neighborhood full of larger homes.
Design is another important thing to consider. Sometimes, architects come up with unique plans that look fantastic, but aren’t financially smart. A building that looks like a giant pineapple would be eye-catching, but it would be needlessly expensive compared to a more mundane alternative.
4. Maximum Productivity
Determining maximum productivity is a bit different depending on the zoning. For residential properties, the most profitable use is normally going to be the one that’s most financial feasibility. More expensive investments aren’t likely to pay off, and going cheap is liable to backfire. When it comes to residential real estate value, “location, location, location” continues to be the rule of thumb. In any given neighborhood, one house is more or less as good as another. The best thing to do is make sure it’s a similar size and design to others in the immediate area.
In most cases, when you have to talk separately about maximum productivity, it’s because you’re looking at commercial properties. Unlike residential homes, far more variables factor into commercial property prices. But the ultimate goal is still the same; to determine the most profitable way to utilize the property. This often requires a market analysis, which will incur additional costs.
To perform an analysis, an appraiser will need to consider multiple possible uses, and evaluate the resulting value. After considering several use cases, the appraiser can then determine which one is the highest and best. Here’s a quick example:
In this example, the big box retail space offers the best return on investment.
| Usage: | Property price: | Construction costs: | Final market value: | Profit: |
| Strip mall | $250,000 | $500,000 | $900,000 | 20% |
| High-density apartment building | $250,000 | $750,000 | $1,100,000 | 10% |
| Big box retail space | $250,000 | $400,000 | $800,000 | 23% |
How Do Appraisers Predict Highest & Best Use?
Appraisers use three different approaches to determine a property’s highest and best use. These are:
1. The sales comparison approach
Sales comparisons, or “comps,” are similar properties in the same area that have recently been sold. By looking at what these properties sold for, you get a rough estimate of your property’s worth.
2. The cost approach
For public buildings like schools and libraries, there’s no financial profit to measure. Instead, appraisers consider what it would cost to rebuild a property, versus depreciation on the current structure.
3. The income approach
Simply put, would a property be worth more if it were put to some other use?
What Are The Key Points In An Investment & Valuation Analysis?
So, what things does an appraiser look at when they’re making their analysis? In general, they’re looking at seven different things:
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Market Trends
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Physical Attributes
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Locational Attributes
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Current Vs. Potential Performance
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Competitive Sites & Comparable Properties
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Existing Use Vs. Modification Costs
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Financial Proformas
Market Trends
Current market trends provide insight into what kinds of returns a property owner can expect. This means paying attention to both the broader rental market and the local market. What is the going rent per square foot for your property type? What are the occupancy rates, and how long are vacancies remaining vacant? All of these things can help you predict your investment’s performance.
Physical Attributes
A run down or obsolete property is not being put to its highest and best use. For example, residential properties are worth less when they have drafty windows or a leaky roof. The same is true for commercial properties that lack modern amenities. In these cases, an assessment will often recommend repairs or upgrades rather than rebuilding or repurposing.
Locational Attributes
Cities and neighborhoods change over time, and different locations become more or less desirable. Perhaps the most wide-scale example of this is the building of the interstate highway system during the middle of the 20th century, when many neighborhoods were cut in two, while other areas received a boom in traffic due to easy interstate access.
Modifications to highways, railway lines, and other transportation can affect a property’s value, both for better and for worse.
Current Vs. Potential Performance
Sometimes, neighborhood trends can shift from one type of property to another. This famously happened in Manhattan, when financial institutions started moving their offices from downtown Manhattan up to midtown. This caused commercial rental prices to crater in the downtown neighborhood.
However, the decrease in prices caused property owners to convert these spaces to trendy new apartment buildings. These converted buildings became hugely popular, and residential real estate prices went through the roof. In this case, if you were assessing a commercial building in downtown Manhattan, you’d need to consider its potential value as an apartment building.
Competitive Sites & Comparable Properties
If you’re developing a vacant lot, you need to think about how many local properties are suitable for the same purpose. This is necessary because there’s always the risk that your area experiences a real estate boom. Let’s say you build a strip mall, and over the next decade, eleven more are built on the same stretch of road. That’s liable to lower the amount of rent you can charge, impacting the property’s value.
Existing Use Vs. Modification Costs
Modifying an existing property will incur expenses. Even if the modified property will be worth more, you have to consider whether it’s worth the upfront investment.
Financial Proformas
As a matter of course, you should always estimate potential value as conservatively as possible. It’s better to err on the side of caution, and not overestimate your property’s potential value.
How Is Highest & Best Use Determined For Vacant & Improved Properties?
For improved properties, highest and best use is calculated by comparing your current use to other potential uses. This includes a baseline comparison to what the property would be worth if it were vacant. If your property would actually be worth more if it were undeveloped, it’s functionally obsolete, and extensive work is necessary.
For vacant properties, the calculation is a little bit different. Because developing a property is expensive, you need to consider the possibility that the land really is more profitable as empty space. If development costs are simply too high to be realistic, it can make sense to sit on empty land for several years.
Summary
The highest and best use of any given property is the most profitable possible use. This can be commercial or residential, high- or low-density, or even as a vacant lot. While it doesn’t take social and environmental factors into consideration, it remains a valuable metric for real estate investors.
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