Highest and best use
Encyclopedia
Highest and best use, or highest or best use (HBU), is a concept in real estate appraisal
that shows how the highest value for a property is arrived. In any case where the market value
of real property is sought, that value must be based on its highest and best use. Highest and best use is always that use that would produce the highest value for a property, regardless of its actual current use. The Appraisal Institute of Canada defines highest and best use as this:
The prior quotation shows that there are a series of tests which any proposed or theoretical use of a property must pass, before it can be the highest and best use of the property.
In some cases, a proposed use might be the highest and best use but for some cost that changes the net economics. An example might be an industrially-used site that is now legal for highrise residential buildings. However, the cost to clean up (remediate) the site is so expensive that the value as currently used is higher. In that case, if it can be continued, the existing industrial use would likely be the highest and best use.
In some cases, appraisers are given specific instructions as to an assumed highest and best use. This use might not pass the tests discussed below as a legitimate highest and best use and may very well produce a different value. One example of this might be a parkland valuation, where the appraiser has been instructed to ignore all other possible uses.
, uses forbidden by government regulations, and uses prohibited by deed restrictions or covenants.
Properties with a use that predates existing zoning or other property regulations may be legally nonconforming. Such grandfathered uses are generally legal even though they do not meet current zoning or other regulations. Since their use predates these regulations, 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.
"Legally allowable" can be a tricky conceptual test, because even uses that are currently not permitted may be considered. This happens when there is a reasonable prospect (at least 50%) that the regulation, zoning, deed restriction, etc. can be changed to permit the proposed use.
Price of Site: $100,000 (remains unchanged in all three examples)
Cost to construct 10000 sq ft (929 m²) industrial warehouse: $750,000
Market Value of 10000 sq ft (929 m²) industrial warehouse: $910,000
Profit for industrial development: 7%
Cost to construct 10000 sq ft (929 m²) retail strip center: $1,500,000
Market Value of 10000 sq ft (929 m²) retail strip center: $1,840,000
Profit for retail development: 15%
Cost to construct 10000 sq ft (929 m²) of residential condominiums: $1,200,000
Market Value of 10000 sq ft (929 m²) of residential condominiums: $1,534,000
Profit for residential development: 18%
As the examples illustrate, even though the retail development results in the overall highest market value for the development, the residential development scenario results in the highest net return to the developer and this makes it the maximally productive use.
For example, house A in a residentially zoned area may have a highest and best use as vacant and a highest and best use as improved that are both residential. A similar house B in a commercially zoned area may have a highest and best use as vacant as a commercial lot and highest and best use as improved as a single family residence.
If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the as vacant value of the commercial lot. For example, assume that "House B" has a value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to demolish the house and prepare the site at $25,000. The highest and best use of the site is to demolish the house and sell the site as a commercial lot. The market value would be $225,000 ($250,000 site value minus $25,000 demolition cost). However, if the demolition costs rose to $55,000, the highest and best use would be the existing residential use, because the value as a commercial lot (now $195,000) would not exceed the existing value as a residence.
This would be the highest and best use of the property, even though it is contrary to
what actually exists.Even if the house is not razed and the site sold as a commercial
lot, the highest and best use is the commercial lot use. The market value of the
property is driven by this hypothetical conversion, even if it never takes place due to the
utility that this potential conversion would bring to a purchaser.
and substitution
drive the highest and best use analysis. The highest and best use of a property determines its utility to a potential
purchaser. The purchaser of such a property would pay no more than a competing property with the same utility while a seller would accept no less than a seller of a comparable property. That is true to the neighborhood.
According to an article on the United States Fish and Wildlife Service
website:
In appraisals, an entity is assessed at its highest or best use to maximize value and increase revenue. However, the value of an entity at its highest or best use may not be greater than the value of an entity in its present use if remediation is required to convert the entity to a different use.
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
that shows how the highest value for a property is arrived. In any case where the market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
of real property is sought, that value must be based on its highest and best use. Highest and best use is always that use that would produce the highest value for a property, regardless of its actual current use. The Appraisal Institute of Canada defines highest and best use as this:
HIGHEST AND BEST USE: the reasonably probable and legal use of property, that is physically possible, appropriately supported, and financially feasible, and that results in the highest value.
The prior quotation shows that there are a series of tests which any proposed or theoretical use of a property must pass, before it can be the highest and best use of the property.
In some cases, a proposed use might be the highest and best use but for some cost that changes the net economics. An example might be an industrially-used site that is now legal for highrise residential buildings. However, the cost to clean up (remediate) the site is so expensive that the value as currently used is higher. In that case, if it can be continued, the existing industrial use would likely be the highest and best use.
In some cases, appraisers are given specific instructions as to an assumed highest and best use. This use might not pass the tests discussed below as a legitimate highest and best use and may very well produce a different value. One example of this might be a parkland valuation, where the appraiser has been instructed to ignore all other possible uses.
Test of highest and best use
In order to be considered as the highest and best use of a property, any potential use must pass a series of tests. The exact definition of highest and best use varies, but generally the use must be the following:- legally allowable
- physically possible
- financially feasible
- maximally productive
Legally allowable
Only those uses that are, or may be, legally allowed are potential highest and best uses. This may exclude uses that are not, and unlikely to become, allowed by zoningZoning
Zoning is a device of land use planning used by local governments in most developed countries. The word is derived from the practice of designating permitted uses of land based on mapped zones which separate one set of land uses from another...
, uses forbidden by government regulations, and uses prohibited by deed restrictions or covenants.
Properties with a use that predates existing zoning or other property regulations may be legally nonconforming. Such grandfathered uses are generally legal even though they do not meet current zoning or other regulations. Since their use predates these regulations, 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.
"Legally allowable" can be a tricky conceptual test, because even uses that are currently not permitted may be considered. This happens when there is a reasonable prospect (at least 50%) that the regulation, zoning, deed restriction, etc. can be changed to permit the proposed use.
Physically possible
Any potential use must be physically possible given the size, shape, topography, and other characteristics of the site. For example a 40000 square feet (3,716.1 m²) single story warehouse would not fit on a 10000 square feet (929 m²) site; therefore, that use would fail the physical possibility test.Financial feasibility
The highest and best use of a property must be financially feasible: the proposed use of a property must generate adequate revenue to justify the costs of construction plus a profit for the developer. 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 less reversion/demolition costs, 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. These three hypothetical development scenarios follow to illustrate the test of maximally productive use.Price of Site: $100,000 (remains unchanged in all three examples)
Cost to construct 10000 sq ft (929 m²) industrial warehouse: $750,000
Market Value of 10000 sq ft (929 m²) industrial warehouse: $910,000
Profit for industrial development: 7%
Cost to construct 10000 sq ft (929 m²) retail strip center: $1,500,000
Market Value of 10000 sq ft (929 m²) retail strip center: $1,840,000
Profit for retail development: 15%
Cost to construct 10000 sq ft (929 m²) of residential condominiums: $1,200,000
Market Value of 10000 sq ft (929 m²) of residential condominiums: $1,534,000
Profit for residential development: 18%
As the examples illustrate, even though the retail development results in the overall highest market value for the development, the residential development scenario results in the highest net return to the developer and this makes it the maximally productive use.
Vacant and improved
The Test of Highest and Best Use is applied to an improved properties both as improved and as if vacant. Vacant properties are generally only given the as vacant test. The Highest and Best Use as vacant may be the same or different as the Highest and Best use as improved.For example, house A in a residentially zoned area may have a highest and best use as vacant and a highest and best use as improved that are both residential. A similar house B in a commercially zoned area may have a highest and best use as vacant as a commercial lot and highest and best use as improved as a single family residence.
If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the as vacant value of the commercial lot. For example, assume that "House B" has a value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to demolish the house and prepare the site at $25,000. The highest and best use of the site is to demolish the house and sell the site as a commercial lot. The market value would be $225,000 ($250,000 site value minus $25,000 demolition cost). However, if the demolition costs rose to $55,000, the highest and best use would be the existing residential use, because the value as a commercial lot (now $195,000) would not exceed the existing value as a residence.
This would be the highest and best use of the property, even though it is contrary to
what actually exists.Even if the house is not razed and the site sold as a commercial
lot, the highest and best use is the commercial lot use. The market value of the
property is driven by this hypothetical conversion, even if it never takes place due to the
utility that this potential conversion would bring to a purchaser.
Economic theory
The economic concepts of utilityUtility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....
and substitution
Substitute good
In economics, one way we classify goods is by examining the relationship of the demand schedules when the price of one good changes. This relationship between demand schedules leads economists to classify goods as either substitutes or complements. Substitute goods are goods which, as a result...
drive the highest and best use analysis. The highest and best use of a property determines its utility to a potential
purchaser. The purchaser of such a property would pay no more than a competing property with the same utility while a seller would accept no less than a seller of a comparable property. That is true to the neighborhood.
Other HBU Considerations
HBU is a designation to identify an entity that could have a higher value if used for a different purpose.According to an article on the United States Fish and Wildlife Service
United States Fish and Wildlife Service
The United States Fish and Wildlife Service is a federal government agency within the United States Department of the Interior dedicated to the management of fish, wildlife, and natural habitats...
website:
“These (HBUs) are defined as lands which have higher values for their non-timber amenities such as for recreation and conservation.”
In appraisals, an entity is assessed at its highest or best use to maximize value and increase revenue. However, the value of an entity at its highest or best use may not be greater than the value of an entity in its present use if remediation is required to convert the entity to a different use.