Different CRE stakeholders bring different needs to the appraisal process. For investors, identifying properties that have the potential for appreciation is paramount. For developers, the appraisal process can reveal which properties would benefit most from renovation or adaptive reuse. Lenders’ assessments of risk rely on accurate, principle-driven appraisals. Property owners have a whole host of business decisions to make, from determining lease terms to adding amenities to putting their property on the open market.
One commercial property value metric can help satisfy all these different needs: highest and best use (HBU). As such, HBU plays a significant role in each and every appraisal report, regardless of which valuation methodology the appraiser has applied to the subject property.
What is Highest and Best Use (HBU)?
A highest and best use analysis seeks to measure a given property’s economic potential; specifically, that property’s ability to generate the maximum value under a set of circumstances that are both ideal and real.
The Appraisal Institute provides a working definition of HBU in The Appraisal of Real Estate. According to the most recent edition (15th, revised in 2020) of this text:
The highest and best use of property is essentially the reasonably probable use that results in the highest value. … At its core, highest and best use analysis is an examination of alternative uses of a property, each use having its own characteristics related to the value-influencing factors of utility, demand, effective purchasing power, and scarcity.
Although this definition is very nearly the final word on HBU, it requires unpacking. To start, HBU is “reasonably probable.” Therefore, a property’s current use (or “utility”) may not be its highest and best use. The overall volatility of the CRE market often means that a property’s highest and best use is different from its current use.
For example, a property is currently being used as office space. An appraiser determines that, due to a variety of factors, the property’s HBU is multifamily. Therefore, the stated property value will be based on the property’s potential multifamily use, not its current use as office space.
“Scarcity” meanwhile, pertains both to the subject property’s market area and its overall marketability. Each factor can influence the other.
Also, as noted, appraisers must analyze any number of alternative uses before they can reach a conclusion about which use qualifies as the HBU. The Appraisal of Real Estate refers to this as a “screening process.” Hypotheticals are inherent in this process, but each one should be grounded in data.
Finally, those alternative uses entail varying degrees of specificity. Depending upon the appraisal requirements and the appraiser’s findings, HBU can be stated in general or granular terms. An example of the former would be a class of uses, such as industrial. An example of the latter would be a type of industrial property, such as a distribution center.
The Four Tests of Highest and Best Use (HBU)
Traditionally, commercial appraisers have followed a four-step process to determine a subject property’s HBU. Each of these steps can also be considered a test, and each test can be expressed as a question the appraiser sets out to answer.
- What is physically possible?
- What is legally permissible?
- What is financially feasible?
- What is maximally productive?
For the purposes of this discussion, we will take each question in turn, as they cannot be asked out of order. That is, a proposed use must pass the first two tests before it can be subjected to the latter two tests. Unless a proposed use is physically possible and legal permissible, its financial feasibility and productivity are irrelevant.
Test #1: What Is Physically Possible?
HBU is contingent on what is “physically possible.” Location, topographic features (e.g., exposure to flood risk), access to infrastructure, and a building’s own condition and dimensions all impose constraints within which the appraiser must operate when assessing what a property’s highest value might be — and how it might realize that value.
For example, a large, rectangular lot that is located near the interaction of several major highways might be well-suited for a retail development. However, a 30-year-old, 7-story structure located in a central business district served primarily by public transportation is more likely to achieve its HBU by hosting office space.
The property features that are most relevant to HBU will vary from property type to property type. For example, overall aesthetics and proximity to cultural resources (e.g., movie theaters, museums, public parks, etc.) are likely to exert a stronger influence on the value of a multifamily development than they are an office tower. However, the number of households located within walking distance of a retail center is likely to impact its value.
Test #2: What Is Legally Permissible?
Appraisers typically research five areas when verifying the legality of a potential property use. Those areas are:
- Land use regulations.
- Building codes.
- Restrictive covenants.
Land use regulations are rules that govern how land can be used, developed, and built upon. The Environmental Protection Agency (EPA) expands on this definition, noting that land use should not be conflated with those natural features that dictate what is physically possible from a development perspective. “Land use is generally a function of laws, policies, or management decisions that may not always be possible to infer by examining the ground via surveys.”
Land use regulations are typically enacted by local governments, such as cities and counties. They are primarily designed to promote public health, safety, and welfare.
Density restrictions, setback requirements, and environmental protections are all examples of land use regulations. Density restrictions limit the number of buildings that can be built on — or people who can be accommodated by — a given piece of land. Setback requirements specify the distance buildings must keep from property lines and roadways in order to preserve open space and create a more aesthetically pleasing environment. Environmental protections seek to mitigate the potentially harmful impacts of development. These protections may restrict the use of certain building materials, require the installation of pollution control equipment, or set aside land for conservation.
Zoning refers to the process of dividing land into different zones, each with its own permitted uses. For example, a residential zone might only allow single-family homes, a commercial zone might allow businesses, and an industrial zone, while commercial, might be reserved for manufacturing facilities.
Zoning rules are technically ordinances. As such, they are typically enacted by municipal authorities. However, these ordinances are subject to review and approval by state governments. They can be changed or amended — and entire areas can be rezoned — but this process is typically complex and time-consuming. Nevertheless, in some circumstances, appraisers may have to consider the possibility of rezoning in assigning HBU. A specific lot or parcel of land may be rezoned based on consideration, and a developer or property owner may apply for a zoning exemption, known as a variance.
Zoning can dramatically impact HBU. For example:
- A zoning ordinance might prohibit some businesses (e.g., liquor stores) from being located within a certain distance of schools or churches.
- A zoning ordinance can require that businesses provide parking — for example, one parking space per 100 square feet.
- A zoning ordinance might require that all new buildings in a particular area adhere to specific architectural requirements.
- A zoning ordinance might limit the height of buildings to a certain number of stories or require a minimum lot size.
- A zoning ordinance may specify the size, type, and location of signs that can be displayed in a particular area, thus impacting the visibility a business might achieve.
Building codes are locally enforced regulations that govern the construction of buildings, from materials used to methods employed. These codes also ensure the integrity of the completed building. Integrity in this context takes several forms.
- Structural integrity. Building codes require that buildings be structurally sound and able to withstand the forces of nature, such as wind, rain, and natural disasters.
- Mechanical integrity: Building codes require that buildings have a safe and reliable water supply, sanitation system, and HVAC system.
- Means of egress: Building codes require that buildings have adequate exits to allow occupants to escape in the event of a fire or other emergency.
- Fire prevention and control: Building codes require that buildings are equipped with sprinklers, smoke alarms, and other fire safety features.
- Accessibility: Building codes require that buildings be accessible to people with disabilities.
- Energy efficiency: Commercial real estate can leave a large carbon footprint. Building codes increasingly include “green” requirements for electrical, lighting, heating, cooling, and other systems that consume energy. These codes are not necessarily limited to new construction. They can also apply to retrofitting, interior design, routine operations, and maintenance.
Consequently, building codes restrict the types of uses that are permitted on a property. More importantly, they can increase the cost of construction, which can make it less feasible to develop a property for certain uses.
Restrictive covenants are clauses in a deed, lease, or other contractual document that limit the use of a property. In some cases, restrictive covenants may prohibit specific businesses from operating out of a property. Moreover, if a property is subject to several restrictive covenants, it may be worth less than a similar property that is free from such restrictions.
Easements are also known as nonpossessory interests in land. In other words, although the easement holder does not own the land, they have the right to use it for a specific purpose. Easements can be created by agreement between the landowner and the easement holder, or they can be created by law.
Easements may be affirmative or negative.
- Affirmative easements grant the easement holder the right to do something on the land, such as cross it with a road (also known as an access easement) or connect to water or energy infrastructure (also known as a utility easement).
- Negative easements grant the easement holder the right to prevent the landowner from doing something on the land, such as building a structure or blocking a view.
Easements can affect the highest and best use of a property in several ways. Easements can:
- Make it more difficult to develop the property. If an easement limits the types of uses that are permitted on a property, it may make it more difficult to develop the property for a particular use. For example, a drainage easement may prevent the construction of a building on a property.
- Reduce the value of the property. If an easement limits the types of uses that are permitted on a property, it may make the property less desirable to prospective buyers.
- Create a conflict between the easement holder and the landowner. If the easement holder and the landowner have different plans for the property, it may create a conflict between the two parties.
Easements can also have a positive impact on highest and best use. For example, a utility or access easement may make it possible to develop a property that would otherwise be inaccessible.
Test #3: What Is Financially Feasible?
Ultimately, a property’s highest and best use must meet two criteria:
- It must generate enough revenue to cover the costs of construction and/or property improvements.
- It must generate enough revenue to turn a profit.
The financial feasibility test is primarily concerned with this first question. As such, “financially feasible” is perhaps better understood as “economic feasibility.” This economic feasibility encompasses everything from the local supply of and demand for properties with a similar HBU to capital expenses (such as property improvements), operating expenses (such as continuing maintenance), and the revenue the property can be expected to generate.
In assessing financial feasibility, appraisers must give appropriate weight to both current and future market conditions. Appraisers typically leverage tools such as comps and data such as occupancy rate, inventory, deliveries, net absorption, time on market, and average price per square foot when gauging current market conditions.
Because highest and best use analyses span multiple property types, appraisers will also gather data and study trends that point to any convergences or divergences — that is, that reveal how the value of different asset classes may be moving in lockstep or opposite directions.
Finally, when analyzing a property’s potential development, appraisers must examine both existing properties and vacant land. Renovations, improvements, and other upgrades can increase the value of existing properties. But the development of vacant land may create more value, especially during real estate and construction booms. Under such circumstances, vacant land often demands more of a premium than existing properties. The result could be that the subject property’s HBU requires the demolition of an existing structure. HBU analyses that are not sensitive to possible shifts in the competitive landscape tend to rest on shakier foundations than those that do.
Test #4: What Is Maximally Productive?
Recall that a property’s highest and best use must meet two criteria:
- It must generate enough revenue to cover the costs of construction and/or property improvements.
- It must generate enough revenue to turn a profit.
The final test appraisers apply in establishing HBU pertains to this second question.
By this stage of the process, the appraiser will have narrowed the field of possible property uses to a handful of top candidates. They then rank these proposed uses and identify which qualifies as the HBU based on its productivity, typically measured in terms of the revenue generated by rent changed to building occupants.
Establishing productivity requires the use of financial formulas such as net operating income (NOI), capitalization rate, discounted cash flow, and the Capital Asset Pricing Model (CAPM).
All that being said, HBU cannot be reduced to a number. HBU is both quantitative and qualitative. HBU is dependent upon the stakeholders involved, the actions they take, and the timing of those actions. So, although there is often little overlap between the property buyer and the tenants occupying that property, both parties are major characters in the HBU narrative.
Windows of opportunity can open and close unpredictably in today’s commercial real estate market. Whether you’re a buyer, seller, lender, or investor, the most accurate and up-to-date data is more valuable than ever.
That’s why our valuation experts, including the members of our dedicated research team, always stay proactive, taking extraordinary measures to ensure their reports contain credible — and actionable — business intelligence.
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