How to Determine the Highest and Best Use of a Property
Highest and best use is inextricably tied to property appraisals. The factors which determine the highest and best use of a property go beyond the current purpose of a specific property, but also the potential value and overall profitability linked to alternative uses. For commercial real estate investors, there are four major criteria used to determine the highest and best use of a property.
Is the Use Physically Possible?
Before commercial real estate investors even think about zoning and legalities, they need to consider if using a property in a certain way is physically possible. The climate, soil type, lot size, the shape of the land parcel, water conditions and more need to be taken into consideration. Building an airport on a mountain peak, or constructing facilities larger than the property itself are exaggerations, but they are examples of what appraisers mean when they test whether the use of a property is physically possible. Incidentally, this test to determine the highest and best use of a property is typically the easiest to pass compared to the others.
Is the Highest and Best Use Legal?
The legal use of a property is a bit trickier than understanding physical possibilities. Zoning regulations can restrict the use of a property. Properties in residential areas may have covenants which exclude specific uses. Even something as simple as improvements and renovations may be in direct conflict with regulations in the immediate area. Whether the use of a property is legally permissible is not a straightforward process. A lot of research must be performed ahead of time. Even then, zoning and other restrictions are subject to change. This happens a lot in areas where once-residential properties get rezoned as commercial, due to gradual developments over the span of years.
Whether the use of a property is financially feasible, more criteria come into play. Investors need to perform an in-depth market analysis to see if there is a void to be filled or if the immediate area is saturated by similar properties. Cash flow estimates need to be run. Data needs to be collected to create forecasts for constructions costs, development and operating expenses, rent, turnover rates, residual values, absorption, and more. The net present value that results from this information will be used to calculate whether or not the use of a property is financially feasible when compares to the rate of return. If a property passes this test, it can move onto the fourth and final step.
Maximally Productive Property Use
The final step uses all of the information from the previous three to determine the highest and best use of a property. All proposed uses that fit the requirements up to this point are listed in order based on the rate of return and value. Keep in mind that risk should also be figured into the assessment of potential uses. A particular use for a property may have very high returns, but the accompanying risk makes the project not worth the effort. Ideally, investors should choose the intended use that has the highest returns and net present value to get the maximally productive use for a property.
Financing the Highest and Best Use for Your Properties
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