For the most part, regardless of what it is, we want to use what we own as best as they are capable.
The same goes for real estate property. Purchasing property or a piece of land but not using it in a valuable way is merely a waste of good real estate.
Here we’ll find out the meaning of highest and best use and how to find the best use of a property.
Definition of Highest and Best Use in Real Estate
The highest and best use analysis concept is a form of real estate appraisal that considers not only the best use of the property but any potential use or gains that may come from future ventures.
According to the Appraisal Institute, the definition for highest and best use is 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.
Understanding what gives your property the most value will allow you to move forward with plans or projects to get the most out of your property.
The Appraisal Institute has determined four tests that include factors that real estate appraisers should consider before identifying the highest and best property use.
Four Tests for Highest and Best Use
The concept of these four tests is to determine a potential use that results in the highest and best use of either vacant property or alternative uses to improve the site’s current use.
These tests are:
- Is the use legally permissible?
- Is the proposed use even physically possible?
- Is the use financially feasible?
- Will the potential use be maximally productive for the investor?
They are further explained below.
Is the use of the land legally permissible? The first step to knowing the highest and best use of the land is understanding the legal regulations of building in the area.
You will have to understand some legal terms and considerations to see if the land’s potential use is allowed by law.
Does the proposed use follow local zoning requirements and regulations? The appraiser must be aware of the specific laws required on the kinds of uses allowed in the property area.
For example, buildings on the property must conform to any and all building codes and government regulations, or other uses or improvements also need to stick to any restrictions placed on the property.
As a property owner, researching and understanding the laws on the legal use of vacant land is your responsibility.
Even though it may require some time and effort, once you are aware of the legal permissibility, proposing a development will be more straightforward.
Is the proposed use of the property even physically possible? To find out the highest and best use of the property, you must also understand the property’s physical capacities.
Although this concept may seem obvious, one could easily get carried away with proposals and planning developments without first considering whether or not the potential use would be physically possible on that specific piece of real estate.
In researching if it is physically possible, the land’s size, shape, topography, lot size, soil conditions, and natural environment all need to be considered before building upon it.
Before the development can even be conceptualized, you need to ascertain you have the property physically suited to hold the real estate structure you wish to build.
For example, it would be impossible to build a 500 square-foot structure on a 300 square foot lot or a marble or cement building on soft clay soil.
On this test for the highest and best use, the appraiser must consider the proposed use of the site and each of the features required for the improvements of the development use.
Suppose the use of the property is physically possible and legally permissible.
In that case, the next step in determining its highest and best use is if the development of the property is financially feasible.
The user must generate the highest profit for the investor.
Financial feasibility is all about finding how the property would benefit economically from the proposed use. The proposed use must also suit the market of the local area.
For example, if a particular area has several office spaces, then putting up another office space would not be the best idea.
That said, this isn’t just about putting up office space but finding out if proposed uses are financially feasible.
To do this, an appraiser needs to conduct a market research and analysis.
Market research will verify the price at which a property will be profitable in the future. Through market analysis, the appraiser can compare different property types and their market value.
Comparing the prices of each property in the area with the real estate property you have will give you a good idea of your property’s market value and an estimate of the highest value you could price the property.
Once you have determined the market value and done a market analysis, one of the most important steps is to develop a Pro-forma forecast to see if the site use would be financially feasible. To create this forecast, there are different kinds of data that are needed.
The appraiser will need to take note of:
- Development expense
- Operating expense
- Vacancy rate
- Discount rate
- Absorption rate
- Cap rate
- Residual value
Once all of this has been calculated, the appraiser will need to estimate the Pro-forma net operating income in the amount of time you hold the real estate investment.
Should the property pass these tests for financial feasibility then, you can move on to the last step in finding out the highest and best use of the property.
Maximally productive use means that the potential uses of the property are optimizing the potential of the land.
This final step of determining the highest and best use of a property will take all of the potential uses and rank them in order of highest value or return on investment.
While ranking the potential uses, it is crucial that the risks involved are also considered. A high reward possible use might also have a more significant risk factor than any of the other proposed uses.
The appraiser must keep in mind to choose the use that is MOST productive and financially feasible in the future.
Another way to address this issue would be to use a discount rate equivalent to the level of risk while computing for the net present value of any current use or existing use.
This way, you’ll be able to see which one of the uses has both the highest rate of return on investment as well as the highest net present value.
These data will show you which potential development or site improvement is the highest and best use.
Why Are These Tests Important?
The tests, as mentioned above, intuitively make sense together.
If any proposed use is neither legally allowed nor physically possible, then it’s apparent the proposed use will not be the highest and best use.
Likewise, for example, the proposed use is legal and physically possible, but it does not suit the local area’s market demographic, then it will not improve maximum productivity.
This means it is not the highest and best use not only of the land but also for the investor.
Conducting these tests for the highest and best use will require much more in-depth research and analysis than regular real estate market valuations.
It is also your responsibility as a property owner to be aware of these processes before entering into any potential business venture or looking into a proposed use.
In this article, the four-factor test for highest and best use was discussed as well as the importance of using these questions and identifying the highest and best use of land.
Conclusive answers to some of these four factors that are used to determine the highest and best use may require the input of experts in other areas.
To execute a highest and best use analysis well, you must hire an attorney or land-use expert who fully understands the procedures that go into the highest and best use valuation.
It will be an excellent investment to find an analyst who is aware of the proper and necessary steps that need to be considered throughout the analysis.