A rather fundamental and indispensable concept in real estate is known as the “Highest and Best Use.”
You may wonder why such a term deserves your attention.
Well, understanding this concept is akin to acquiring a lens that reframes your view of any piece of real estate, from a quaint suburban cottage to a towering urban skyscraper.
It is the touchstone that, once understood, offers insight into why properties are valued the way they are, and why decisions are made in the ways they are within the sphere of real estate.
In this blog post, we’ll dig deep into what “highest and best use” really means.
We’ll look at the criteria that underline it, how it affects property values, and bring the theory to life with real-world examples.
1. What Does Highest and Best Use Mean?
Consider a blank canvas: what might it become in the hands of an inspired artist?
There is near infinite potential — just waiting for the right artist to apply their brush.
This is like the premise of “highest and best use” in real estate, a theoretical brushstroke that brings out the greatest potential of a property.
The concept essentially refers to the most profitable and efficient use of a piece of land or property, which is legally permitted, physically possible, financially feasible, and results in the highest value.
Each parcel of land or property is unique, with a distinct blend of characteristics and potential.
The highest and best-use concept helps us visualize these possibilities and shapes our understanding of what a piece of property can become.
Imagine a plot of land in the heart of a bustling city, brimming with traffic and surrounded by high-rise buildings.
Would the highest and best use be a single-story bookstore or a multi-story office complex?
The concept not only questions the current use but encourages us to think about the property’s optimal potential in terms of productivity, value, and contribution to its environment.
2. The Four Test Criteria for Highest and Best Use
The highest and best use principle might seem like an abstract concept; however, it’s grounded in a concrete four-part test, acting as an analytical compass that guides us to the most promising utilization of a piece of property.
These four criteria—legally permissible, physically possible, financially feasible, and maximally productive—form the pillars of the highest and best use analysis.
Legally permissible
The first port of call in our analysis is determining the legal permissibility of the proposed use.
No matter how grandiose or lucrative an idea may be, it is grounded by the laws and zoning regulations set by local authorities.
These laws dictate what activities can be performed on a piece of property and the types of structures that can be built.
For example, an area zoned for residential use cannot suddenly sprout a factory.
Understanding these rules is a crucial starting point in defining the highest and best use.
Physically possible
Next, we must look to Mother Nature and the architectural limits that constrain our plans.
We may have a legally permissible idea, but is it physically feasible?
- Can the land support the weight of our proposed building?
- Is there enough space for the necessary infrastructure and utilities?
- Is the property prone to flooding or other natural disasters?
When assessing physical possibilities for the property, the appraiser must evaluate elements such as the property’s size, shape, how accessible it is, the available utilities, and other intrinsic physical characteristics.
If a project is to be physically possible, it must pass the tests of architecture, engineering, and geology, among others.
Financially feasible
Having a use that is legally permissible and physically possible is commendable, but it means little if the project is not financially feasible.
In other words, will the proposed use generate enough returns to justify the costs involved in its development and operation?
A proposed luxury hotel might be an ideal use for a downtown plot, but if the market can’t support the room rates necessary for profitability, the project would be a financial failure.
Maximally productive
The final criteria takes us beyond mere feasibility into the realm of optimization.
Is the proposed use maximally productive?
This refers to the use that yields the highest return or value to the property over a period.
This doesn’t necessarily mean the immediate maximum financial return; it considers long-term profitability and sustainability, taking into account market trends and economic forecasts.
This stage serves as the final checkpoint, ensuring that the proposed use of the property is not just possible and permissible, but indeed the highest and best use.
3. Relationship Between Highest and Best Use and Property Value
When it comes to the value of real estate, the highest and best use concept plays a significant, often pivotal, role.
Just as the star ingredient can define a gourmet dish, this principle largely shapes a property’s worth.
To fathom the depth of this relationship, let’s explore how it influences real estate appraisals and market values, followed by tangible examples that illustrate this intricate connection.
4. How It Influences Property Appraisal and Market Value
An appraisal is, at its core, a professional opinion on the value of a property, and the highest and best use concept is an important cog in the gears of this valuation process.
The value attributed to a property is inherently linked to its potential use—each use carries a different value proposition.
For instance, a vacant plot of land in a city center could have its value drastically change depending on whether its highest and best use is as a parking lot or a high-rise commercial building.
Market value, meanwhile, is influenced by the expectations of typical buyers, who often base their decision on what they perceive as the property’s highest and best use.
Hence, a property’s market value is often aligned with its highest and best use.
This underlines the importance of accurate highest and best use analysis for property owners, potential buyers, and investors alike.
5. Examples To Illustrate This Relationship
Let’s consider a real-life example.
Imagine a charming, antiquated farmhouse located on the outskirts of a rapidly growing city.
Its current use as a residential property may have a certain value attached to it.
However, if its highest and best use—considering changing demographics, city expansion, and local regulations—is found to be a commercial development like a shopping mall, the property’s potential value could skyrocket.
Have you ever watched a movie scene where a little old lady refuses to sell her property to ravenous developers?
We often see this scenario play out in movies and TV shows, where persistent developers constantly make offers to homeowners in order to vacate their properties.
What may seem like sheer obstinacy is often strategic positioning.
These developers, with their eyes set on future profits, see past the quaint charm of the farmhouse to the buzzing shopping mall or high-rise condominium it could become, hence their dogged pursuit.
In this dance between present charm and future profits, the highest and best use of a property reveals itself to be the true leading character.
Similarly, let’s consider an older office building located in the heart of a bustling metropolis.
With the advent of remote working trends and changing business needs, its highest and best use might shift from commercial to residential.
This change in use could greatly influence its value, possibly making it more attractive to developers for conversion into residential apartments.
These examples underscore how a property’s potential use can significantly affect its value.
Hence, understanding the highest and best use concept can provide key insights into property appraisal and market value.
6. How is Highest and Best Use Determined?
Determining the highest and best use of a property isn’t like gazing into a crystal ball, nor is it a whimsical guess.
It is, rather, a rigorous and methodical process that leans heavily on professional judgement, market research, and meticulous analysis.
Let’s dive into the roles played by appraisers and real estate professionals in this process and understand the steps involved in the assessment.
7. The Role of Appraisers and Real Estate Professionals
The quest to identify the highest and best use of a property relies heavily on the expertise of appraisers and real estate professionals.
Appraisers, with their deep understanding of market conditions, zoning regulations, and financial viability, form the backbone of this process.
Their analysis assesses a property’s potential uses against the four-pronged test of legality, physical possibility, financial feasibility, and maximum productivity, to arrive at a considered opinion.
Real estate professionals, on the other hand, apply their market experience and their understanding of potential buyer preferences to evaluate the viability of each use.
They also play a critical role in translating the findings of the highest and best use analysis into actionable strategies, be it for selling, leasing, or renovating a property.
8. The Process of Assessment
The process of determining the highest and best use of a property is a multi-step journey.
It begins with a comprehensive analysis of the property itself, evaluating its physical features, location, and existing improvements, if any.
This is often followed by an in-depth study of the legal constraints, including zoning laws, building regulations, and any other relevant legal limitations.
Next, a thorough market analysis is conducted, studying the demand for different uses of the property and the economic feasibility of each.
This includes an analysis of the competition, potential net operating income, and costs associated with each possible use.
The final step involves a comparative analysis of the potential uses identified, measured against the four criteria of the highest and best use test.
The use that passes these tests and shows the greatest degree of advantage in terms of net returns or value enhancement becomes the designated “Highest and Best Use” of the property.
This meticulous assessment process ensures that the determined use is not merely an educated guess, but a well-considered professional opinion founded on rigorous analysis and market realities.
9. Importance of Highest and Best Use in Real Estate
In the vast and intricate chessboard of real estate, understanding this concept is like knowing the power of your queen piece.
Its significance reverberates across different players in the real estate field, from property owners to investors, and from urban planners to real estate agents.
Let’s talk about how each of these stakeholders leverages this key concept in their respective domains.
For Property Owners
Property owners stand to gain significantly from the judicious application of the highest and best use principle.
When considering property improvements, for instance, owners can use this principle to guide decisions about renovations or structural changes.
Rather than making changes based purely on personal preference, they can prioritize modifications that align with the property’s optimal use, thereby maximizing its value.
Similarly, when selling or leasing properties, understanding the highest and best use can be a powerful negotiation tool.
It allows owners to showcase the property’s potential and command a price or rent that reflects this value.
It can also help attract the right type of buyers or tenants who see the value in the property’s optimal use.
For Developers and Investors
For developers and investors, the highest and best use concept is an essential tool for identifying profitable opportunities.
When analyzing the potential for redevelopment, this principle helps them understand the different uses a property could be converted into, and the returns each would yield.
It encourages a forward-thinking approach, keeping an eye on market trends and potential shifts in demographics or buyer preferences.
In a broader context, understanding the highest and best use of properties helps investors grasp the nuances of real estate market dynamics.
It allows them to identify underutilized properties, anticipate shifts in property use trends, and make strategic investment decisions.
For Urban Planners and Local Authorities
Urban planners and local authorities also derive immense value from the highest and best use analysis.
It plays a vital role in zoning decisions, guiding authorities in creating zoning laws that allow properties to be used in a way that maximizes their value, while also serving the community’s needs.
Furthermore, this concept is a key component in urban development and planning.
By identifying the optimal use of properties, planners can design development projects that balance economic growth with community welfare, leading to more sustainable and balanced urban growth.
For Real Estate Agents and Brokers
Real estate agents and brokers, the mediators of the real estate chessboard, utilize the highest and best use principle to guide their clients effectively.
They leverage this concept to advise clients on real estate investment decisions, helping them choose properties that hold the potential for high returns.
In addition, this principal aids brokers in facilitating transactions.
By understanding a property’s highest and best use, they can market the property effectively, attract the right buyers or tenants, and help negotiate deals that reflect the property’s true potential.
In essence, the highest and best use concept is a key that can unlock the true value of real estate transactions.
Additional Resources
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.