Part One – What Is The Highest & Best Use?

Part One – What Is The Highest & Best Use?

By James R. MacCrate, MAI, CRE, ASA MacCrate Associates LLC

Highest and Best Use: The reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, and financially feasible and that results in the highest value. The four criteria that highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity.  (The Dictionary of Real Estate Appraisal, 4th Edition Appraisal Institute, Chicago, IL.) 
 
Appraisers are required to determine the highest and best use (HBU) of a subject property to properly form an estimate of market value.  Highest and best use not only determines the most likely use based on economic and market factors, but also provides conclusions that guide the application of the three approaches to value.

 

Highest and best use, rarely pops up in the economic (even land economic literature).  Its history is in the legal literature and is a necessary foundation for market value, which is the legal definition of the economic concept of value/price generated in a perfectly competitive market structure.  Real property markets due to spatial context and location fixity are oligopolies or imperfectly competitive markets at best. The courts use a perfectly competitive context to be equitable, but the result is that it does not fit the context of the “real” market structure and thus results in possible mispricing of assets.

 

Joseph S. Rabianski, Ph.D., CRE stated in Real Estate Issues (Spring 2007) that “Two additional truisms are that the current use of the property may not be the HBU of the property, and the HBU of the property may not correspond to the existing land use allowance.”  A rezoning may be possible and it is probable that it would affect the value of the property.  Very often two real estate appraisers may conclude to a different highest and best use which results in a wide range in values and makes it difficult for judges and mediators to arrive at an accurate estimate of value.  If alternative uses are in effect, then the return to the property would require the consideration of opportunity cost associated with the potential alternative uses that may fit or be appropriate on any given site. These opportunity cost considerations can assist with mediation concerns.

 

Issues in the Current Market 

For example, in the current market, many condominium projects in the New York metropolitan area were not financially feasible from the start, but an appraiser told a lending institution that it was the highest and best use of the property.  The financial institution improperly underwrote the loan and financed the construction project. (The underwriters should have known better.)  The project has been built and the borrower now has defaulted on the loan, but the current highest and best use is and was as an apartment project or maybe even vacant land.  The final valuation conclusions are substantially different.  The value of land for each use is different and the total value of the condominium units are substantially higher than the value of the property operated as rental project. 

 

Physically Possible and Legally Permissible 

Determining the uses that are physically possible and legally permissible result in a set of reasonably probable uses that satisfy the first two tests of the highest and best use analysis.  Expected land use, as determined by zoning limitations and surrounding land uses, as well as existing linkages, market demand and current improvements, limit the highest and best use determination to a fairly predictable set of alternative uses.  Disputes usually come into play regarding the “reasonably probable” uses for a given property, particularly when a property or its local market is in transition or the property itself is impaired and in need of remediation. 

 

Let’s Look At A Few Examples 

Disputes may arise when there is a failure to define the precise bundle of rights being appraised; so that, while all appraisers may be appraising the same address, they are not appraising the identical real estate property interests.  If the rights appraised are not the same, the highest and best use conclusion may be different.  Close examination of the property, occupancy, title and deed will reveal the rights to be appraised.  Only then can prospective uses be deemed legally permissible.

 

Another example of a dispute may be where an appraiser stated the site could not be subdivided and the other the appraiser said that it could.  Examination of zoning ordinances, deed and title restrictions can determine if subdivision is legally and physically feasible.  In New York City, it may be necessary for an appraiser to hire a qualified zoning consultant to interpret the New York City Zoning Ordinance.  This has occurred quite often even when there is a reasonably probable chance that variances can be obtained to increase the intensity of use.

 

Conversion, renovation and alteration (CRA) as well as probable zoning changes should also be  investigated.  CRA is financially feasible if the value after the change is greater than the “as is” value.  Zoning changes may not be required because alternative uses are permissible under the existing zoning regulations.  For example, in Nassau County many industrial buildings that were built in the 1960’s and 1970’s are now being converted to office or retail uses, providing a higher return and represent the highest and best use.

 

Highest and best use analysis is especially important when the property is impaired.  In the case of environmental contamination, for example, the appraiser must perform two highest and best use analyses, as is and as if unimpaired.  Issues to consider include the extent of the impairment and remediation necessary, whether limitations continue to exist after remediation and the extent of impairment that is tolerated by market participants.  The impairment may render certain uses impossible, illegal or unfeasible. 

 

Financially Feasible and Maximally Productive 

Once the appraiser determines a set of uses that are “reasonably probable,” because they are physically possible and legally permissible, the next tests comes into play.  The appraiser then looks at whether each use is financially feasible and which of these uses are maximally productive, or results in the highest present value to the property.  Can the owner achieve sufficient income from the property to justify the investment?  In the examples provided above, timing is critical.  Is there enough demand in the market to support the use over time (i.e. the use does not need to be immediately productive)?  What is the required rate of return or the perceived market risk for each use?  Finally, do these economic and market factors provide adequate support for the alternative uses that fulfill the four criteria?

 

Note – Thanks to Terry Grissom, PhD, University of Ulster, (email – terry.grissom@sky.com or e251744@uucde.ulster.ac.uk and Noreen Whysel who provided great editorial assistance.

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About Jim MacCrate

Real estate appraiser and valuation consultant for more than 30 years specializing in reviewing real estate appraisals, risk management and quality control.
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2 Responses to Part One – What Is The Highest & Best Use?

  1. Pingback: Uniform Appraisal Standards for Federal Land Acquisitions – Sales Comparison Approach – Comparable Sales « Appraisal & Valuation Issues

  2. Matt says:

    In your example of the NYC condo project that should have been an apartment project, or left vacant, isn’t the problem a failure to recognize the cycles in demand for the various types of uses in NYC housing? You state that the value would be higher for the condo, and if there was sufficient demand for such a use that would result in the project being maximally productive.

    The mistake seems to be a failure to recognize that condo construction was exceeding the demand for such housing.

    Maybe the appraisers were using HBU analysis from five years ago when things were still on the way up.

    Like you once said, the hardest part of the cycle to predict is the turning point.

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