Commercial real estate investors often rely on appraisals to accurately assess the value of a property. Appraisals are conducted for a variety of property types, including homes, vacant land, commercial properties, and others.
In commercial real estate, an appraisal focusing on the highest and best use (HBU) is especially significant. This type of evaluation estimates a property’s value based on its optimal use.
What Does Highest and Best Use Mean in Real Estate?
The highest and best use refers to the most profitable and suitable use of a property. It involves assessing a property’s legal, practical, and productive potential to determine the most advantageous option for investors.
In essence, HBU answers the question: “What is the best way to use this property to maximize its value?”
Since investors are generally seeking the highest financial return, the highest and best use is often the primary consideration for property valuation.
The Four Key Criteria for Highest and Best Use
The concept of highest and best use isn’t subjective or based on intuition. It’s clearly defined so that property owners, investors, buyers, sellers, managers, and real estate professionals can accurately discuss the appraisal process.
The HBU must meet four specific criteria: legal permissibility, physical possibility, financial feasibility, and maximum profitability.
- Legal Permissibility A property’s intended use must comply with applicable laws, such as zoning regulations, building codes, and environmental restrictions. Common legal considerations include zoning rules and, for some properties, restrictions due to hazardous materials or high population density.
- Physical Possibility The intended use must also be physically achievable on the property. Factors such as size, shape, terrain, and access are assessed to ensure the property can accommodate the proposed use.
- Financial Feasibility A property’s intended use must be financially viable. The costs involved in developing or modifying the property must not exceed the expected returns. The feasibility assessment focuses on whether the potential income or resale value justifies the investment, regardless of who funds it.
- Maximum Profitability Among all feasible options, the one that generates the highest net return over time is considered the highest and best use. Profitability can come from revenue, appreciation, or other value increases.
Examples of Applying Highest and Best Use
The determination of highest and best use varies depending on the property type. Below are some examples:
- Vacant Land: In a fast-growing residential area, the most profitable use may be developing multi-unit housing or mixed-use buildings. In rural areas, agricultural or industrial uses might be more appropriate.
- Improved Property: A warehouse in a gentrifying neighborhood may be repurposed into residential lofts or retail space, while a run-down apartment building may remain housing, but with renovations factored into the highest and best use.
- New Construction: In regions with a high demand for office space, new commercial developments might be the best option for maximizing profitability, although zoning laws and building codes must be considered.
How Commercial Appraisers Determine HBU
Commercial appraisers use several methods to determine a property’s highest and best use. They conduct market analyses, reviewing trends, economic conditions, and future forecasts. They also project potential revenues, development costs, and profit margins for each possible use. Legal and physical requirements are verified, but most of the appraisal process involves calculating costs and returns.
Conclusion
The concept of highest and best use is a core principle in real estate appraisal, guiding how properties are valued, developed, and sold. A thorough HBU analysis helps investors and developers maximize the profitability and efficiency of their property investments. Always ensure that you complete a comprehensive HBU appraisal when determining a property’s potential value.