The concept of highest and best use is one of the fundamental principles that underlie real estate appraisal. Highest and best use requires that the appraisal considers not just the current use of the property but also the potential value associated with alternative uses. The Appraisal Institute has four tests that appraisers can use in order to narrow down all of the alternatives to one highest and best use of the property.
Four Tests for Highest and Best Use
You can use the following four tests to find the highest and best use of a site as if vacant or currently improved.
1. Is the Use Physically Possible?
The first test of highest and best use simply evaluates whether it is possible to use the land in a certain way. Ignoring the zoning and economics of the proposal, consider whether or not the potential use is physically possible. That means the topography, soil type and conditions, lot size and shape, surface and subsurface water, and even weather patterns must make the development possible. For example, you probably can’t build a marina in the middle of the desert, a heavy marble building on soft clay soil, or a building with a 250,000 square foot base on a 200,000 square foot lot. In addition, an appraiser must not only consider the proposed use of the site but also the characteristics of the optimum improvements for that use. This first test, however, is usually the easiest to pass.
2. Is the Use Legally Permitted?
After eliminating any potential uses that are not physically possible, you can move on to the second test. Whether a potential use is legally permissible involves a few different legal considerations. The proposed use must be allowed by zoning 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 these regulations. Concluding whether or not something is legally permissible is a straightforward process. Regulations, however, can change over time. An area that was zoned for residential development can become designated for commercial development. Just because a proposed development is not legally permissible does not mean that it will always be that way. In such cases, an appraiser must consider the probability of the legal restriction being modified to allow the proposed development. There should be substantial documentation indicating that the regulation will likely be changed to pass to the third test of highest and best use.
3. Is the Use Economically Feasible?
The third test of highest and best use is concerned with the economic feasibility of the proposed use. A use may be physically possible and legally permissible, but it must also make economic sense to be considered the highest and best use. This involves analyzing the costs associated with the potential development, including construction, operation, and maintenance expenses, and comparing them to the projected income and potential resale value. An appraiser should evaluate whether the potential revenue generated by the property would justify the costs involved. For example, if the development of a luxury condominium project requires a significant investment but the expected return is minimal, the use may not be economically feasible despite passing the previous two tests.
4. Is the Use Maximally Productive?
The final test determines if the use is maximally productive. Even if an alternative use meets all physical, legal, and economic criteria, it still may not represent the highest and best use. Appraisers often consider the highest and best use to be the option that yields the greatest net return over time. This may involve not only considering the income generated but also analyzing the benefits derived from the use of the property. Importantly, this test also takes into account the competitive landscape and market demand for different property types. By analyzing market trends and potential demand, appraisers can ascertain whether the proposed use will occupy the highest niche in the marketplace.
Conclusion
Determining the highest and best use of a property requires careful analysis of multiple factors, including physical possibility, legal permissibility, economic feasibility, and maximized productivity. By applying these four tests, appraisers can provide property owners and investors with valuable insights to optimize property value. Understanding the highest and best use can ultimately guide strategic decision-making for maximizing investment returns.
