According to The Appraisal Institute, the highest and best use of a property is defined as:
“The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value.”
The Appraisal Institute defined a set of tests known as The Four Tests, which comprise an appraiser's factors when determining the highest and best use of a property. In this article, the highest and best use for your property, we will examine these four tests and what is legally permissible, physically possible, financially feasible, and maximally productive. This will be kept in the scope of residential real estate, and we welcome the opportunity for you to reach out if you have further interest. Let’s dive in!
Highest and best use (HBU) – also referred to as highest or best use – is a concept that originated with early economists such as Irving Fisher (1867-1947), who conceptualized the idea of maximum productivity. One of the earliest citations of the term is found in the Minutes of the Maine Legislature as early as 1831 in speaking about the assessment and valuation of real estate:
“…the land was classified preceding such change of use, had such real estate been assessed at its highest and best use…”
The concept in real estate appraisal shows how the highest value for a property is arrived at. Where the market value of real property is sought, that value must be based on its highest and best use. The highest and best use is always that use that would produce the highest value for a property, regardless of its current use. 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 potential purchaser. A purchaser will pay no more for a property than a competing property with the same utility would command, while a seller would accept no less than another seller of a comparable property.
Legally permissible – Which use cases are permissible by law, zoning, and other land-use regulations.
A prospective use cannot be considered the highest and best use unless that use would be allowed under:
- Current building codes
- Zoning ordinances
- Environmental laws
- Other government regulations
If building in a residential area with restrictive covenants, the proposed improvements must not violate any rules. The proposed use must conform to all applicable building codes and height limits. In addition, the improvements must adhere to any restrictions imposed by easements on the property. Determining whether a proposed use is legally permitted requires research into the local building regulations and restrictions. Gaining a comprehensive understanding of the applicable legal requirements can be time-consuming, but it is fairly easy to determine whether or not a proposal violates any of these regulations.
Physically possible – Constructing buildings on the side of a mountain or in a swamp probably isn’t possible.
Things that must be considered are the topography, soil type and conditions, lot size and shape, surface and subsurface water, and even weather and fire hazard zones. An appraiser must consider the site's proposed use and the characteristics of the optimum improvements for that use.
Financially feasible – Does the use case of the property suit the demographics and market of the area well?
Financially feasibility goes hand in hand with conducting a market analysis and developing proforma cash flow estimates. You’ll need to collect data to forecast construction and development expenses. Data such as:
- Operating expenses
- Absorption rates
- Vacancy rates
- Discount rates
- Cap rates
- Residual values
After gathering this information, estimate the proforma net operating income over your expected holding period. You can determine which projects meet your particular investment standards by using discounted cash flow techniques.
Discounting cash flows by your cost of capital and computing the net present value, a project is considered financially feasible if the NPV is greater than 0. You can also compute the internal rate of return and compare the property’s return to your acceptable hurdle rate for projects. If your property meets this important feasibility, you can continue towards whether it is maximally productive.
Maximally productive – Does the intended use optimize the potential of the land?
The previous steps eliminated proposed uses that were not physically possible, legally permissible, or financially feasible. The last step takes all of the proposed uses that meet these requirements and ranks them in order of value or rate of return. While ranking proposed uses, it is also helpful to consider the risk associated with the proposed use.
Example: One use might generate a much higher internal rate of return than all of the others. Yet, that high return may be related to the higher risk of that project. Adjust for the risk by applying a discount rate commensurate with the risk level while computing the net present value. The use with the highest internal rate of return and net present value is the maximally productive use.
The maximally productive use of a property is the one that generates the highest returns. This can be determined by considering the physical, financial, and legal feasibility of potential uses and then ranking them based on their rate of return. Risk must also be taken into account when making this determination.
Now that you know how to determine the maximally productive use of a property, you can move on to finding the right property for your investment portfolio.