In real estate parlance, the term, ‘highest and best use’ refers to the legally and physically possible use that, at the time of appraisal, is most likely to produce the greatest net return to the land or buildings over a given period of time. The ‘highest and best use’ concept states that the value of a property is directly related to the use of that property; the highest and best use is the reasonably probable use that produces the highest property value. This ‘highest and best use’, may or may not be the current use of the property being appraised.
Market and competitive property analysis
As indicated by the Occupational & Professional Licensing Administration (2011), the performance of market analysis and a competitive property analysis will make it easier to identify the subject property’s strengths and weaknesses. The Valuer can then consider different alternatives to improve the property’s weaknesses or further enhance its strengths with the ultimate goal to improve overall economic performance. This is also known as determining the property’s highest and best use. This next step is called the Analysis of Alternatives and it looks at the theoretical costs and corresponding increase in rents by making different improvements, even the redevelopment of the subject property. Since each option to increase value may carry an associated cost, the Valuer must determine the economic benefits associated with that investment. Among the alternatives to consider are:
- Rehabilitate the property without altering its existing use
- Modernise the property by updating finishes, purchasing new or more efficient equipment or enhancing existing features or amenities.
- Change the use of the building, including the conversion from one property type to another (i.e. from industrial to single story office), or by demolishing it for a completely new development.
- Conversion to a condominium ownership structure
In evaluating all the alternative programs, the Valuer should consider the costs, the projected payback, the property’s zoning, building codes, neighbourhood characteristics, labour costs (in-house versus contracted), and timing.
Test of highest and best use
The Appraisal Institute (2001) expressed the view that, for any landed property to pass the test of ‘Highest and Best Use’, such use or the potential use of such property must generally be:
- Legally allowable: Only those uses that are or may be allowed can be considered as a potential Highest and Best Use. This may exclude uses that are not now and cannot be expected to be allowed by zoning, uses forbidden by government regulations, and uses prohibited by deed restrictions or covenants. For example, a property that is in an area that is zoned solely for residential houses cannot be legally used for another use. However, properties with a use that predates existing zoning regulations may be legally nonconforming. Legally nonconforming uses, also called grandfathered uses, are generally considered to be legal uses of the property even though they do not meet existing zoning regulations. Since their use predates the zoning regulations that would have made them illegal, they are “grandfathered in”. However, some such uses may not be reproduced if the legally nonconforming improvement is destroyed or damaged beyond a certain point.
- Physically possible: Any potential use must be physically possible given the size, shape, topography, and other characteristics of the site.
- Financially feasible: The highest and best use of a property must be financially feasible. This means that the proposed use of a property must generate adequate revenue to justify the costs of construction plus an acceptable margin of profit or return for the developer/investor. In the case of an improved property, with obvious remaining economic life, the question of financial feasibility is somewhat irrelevant. In the case of an improved property with limited remaining economic life, the question of financial feasibility becomes a question of the maximally productive use of the site. If the value of the land ‘As Vacant’ exceeds the value of the property ‘As Improved’, then redevelopment of the site becomes the maximally productive use of the property and continued use of the existing improvements that do not represent the highest net value of the site is considered to be financially unfeasible.
- Maximally productive use: Finally the use must generate the highest net return (profit) to the developer. A property that could hypothetically be developed with residential, commercial or industrial development might only have one of those uses as its highest and best use.
Furthermore, the principles of value that could help determine ‘highest and best use’ and to establish value, according to Pinal County (2008) are:
- Anticipation: the anticipated future benefits to be derived from the property.
- Balance: the equilibrium reached in a free market when complementary uses of neighbouring property permit maximum value for individual properties and the neighbourhood.
- Change: the continuing effects of economic, social, and governmental forces on the property and its environment, resulting in continuous change in market value which must be anticipated.
- Competition: the tendency of a highly profitable use to be duplicated by others until an excess supply of similar goods and services reduces profitability, and thus value.
- Conformity: the creation of maximum market value through a reasonable degree of similarity of property use, appearance, and owner demographics.
- Consistent use: the requirement to value all aspects of a property: land, improvements, and personal property on the basis of a single class of usage at any given point in time.
- Contribution: the incremental amount of value contributed to the total value of a property by any given component, as opposed to the actual cost of the component.
- Demand: the amount of a commodity, good or service that would be purchased at various prices during a specific period.
- Substitution: the market value of a property is affected by the cost of obtaining an equally desirable and valuable property as a substitute.
- Supply: the amount of a commodity, good or service that would be offered for sale at various prices during a specific period.
- Surplus productivity: the net income after the costs of labour, capital, and management has been paid.
- Variable proportions: When the quantity of one productive service is increased in equal increments, while the quantities of other productive services remain fixed, the resulting increment of product will decrease after a certain point.
Reference
Pinal County (2008). The appraisal process. http://co.pinal.az.us/Assessor/Research/ valuation.asp
