What do the wealthiest investors have in common? They conduct valuations of properties before investing in them.
One method that appraisers use when determining the value of a piece of real estate is the “highest and best use” test. Let’s take a look at how it works:
What Does “Highest and Best Use” Mean?
Essentially, “highest and best use” or HBU is a process that evaluates a given property based on several benchmarks. It is one way to ensure that investors put their money into financially productive properties that provide the highest utility. The HBU considers the current use of the property as well as its potential value when used alternatively.
A piece of real estate’s HBU is determined by real estate professionals including appraisers and brokers. If you’ve hired a property management firm, their property managers are likely adept at determining the HBU.
What are the Different Tests to Determine the HBU?
Appraisers use four tests to determine the HBU of a given property. The tests determine whether the potential use of the property is its highest and best use. All four parameters must be present:
- Legally allowable
- Physically possible
- Financially feasible
- Profitable or maximally productive
#1 Is it physically possible?
The first test evaluates whether a piece of land can be used in a certain way. The appraiser determines what can be constructed on the property, considering attributes such as topography, accessibility, water and soil conditions, lot size and shape, weather patterns, and much more. This stage ignores zoning laws and restraints and merely assesses whether the lot can accommodate the property owner’s proposed development/s.
For example, it would be physically impossible to build a 300,000-square-foot building on a 200,000-square-foot lot. Similarly, it wouldn’t be possible to build a yacht berth in the desert.
#2 Is it legally permitted?
The second test answers the question, “Is the proposed use allowed by law?” It looks into restrictive covenants, zoning regulations, building codes, height limits, easements, and similar restrictions. For example, proposed improvements must adhere to all of the restrictions imposed within a city or state.
To determine if the proposed use is legally permitted, it is crucial to thoroughly research federal, state, and local restrictions. It can be time-consuming, but deciding on whether or not the proposed use or proposed development is legally permissible is generally a straightforward process.
However, keep in mind that restrictions can change. So, don’t be discouraged when the proposed use or proposed development isn’t legally permissible! That’s why it is important to hire an appraiser or property manager who is forward-thinking. He/she must be able to consider the possibility of the legal restriction being lifted in the future. A good appraiser will be able to provide substantial documentation to prove that the restrictions are likely to change.
#3 Is it financially feasible?
This is where things get a bit complicated.
If the proposed use is physically possible and legally permissible, then the proposed use is what you’d call “reasonably probable”. The next step will determine if the proposed use is not just reasonably probable, but also financially feasible.
Financial feasibility is determined by conducting numerous market analyses and calculations, such as pro forma cash flow estimates and NOI projections. The third test requires you to collect a ton of data to accurately project the operating expenses, residual values, vacancy rates, absorption rates, and more. That’s why it’s recommended to hire an appraiser or property manager, otherwise, you might make the wrong calculations.
As a rule of thumb, the property use is deemed financially feasible if the NPV > 0.
#4 Is it maximally productive?
The last test can be conducted only when the prior tests have yielded positive results. That is, if the proposed use is physically possible, legally permissible, and financially feasible. This final test contemplates all of the proposed uses and ranks them according to the internal rate of return (IRR). While ranking, it’s important to consider the risks involved with each proposed use.
For instance, a proposed use with a high IRR may not rank #1 if it is extremely risky. Generally, the proposed use with the highest IRR (after adjustments due to risk) and NPV is the most productive, making it the “highest and best use” for the property.
What Other Tests Can You Conduct?
The HBU process filters out the proposed uses from a physical, legal, and financial standpoint. While it is an effective method, it’s not perfect. When determining the value of a given property, it’s important to take more than one approach, including:
#1 Sales Comparison Approach
The sales comparison approach compares a given property with comparable properties that have recently sold within the same area. It contemplates a variety of attributes including the lot size, amenities, and so on, to determine the improvements that would make the property more profitable or attractive to prospective tenants and buyers.
#2 Cost Approach
The cost approach contemplates how much it would take to rebuild the property from the ground up, taking into account the accrued depreciation. The cost approach is often used for less profitable properties such as libraries and schools.
#3 Income Approach
The income approach or the income capitalization approach allows appraisers to estimate the value of the property based on the income that it generates. It works by dividing the net operating income (NOI) by the capitalization rate.
Is the HBU an Important Process?
The HBU provides a detailed evaluation of the property and its proposed use, making it extremely beneficial to any real estate investment. It analyzes the feasibility of a project from multiple perspectives to ensure that investors get their money’s worth.
The four tests for “highest and best use”, along with other valuation methods, are essential in determining the feasibility of the proposed use of a given property. Before buying a property, whether residential or commercial, consider conducting several analyses to be sure that your real estate investment goals are feasible.
The financial analysts and real estate professionals at Luxury Property Care would be delighted to conduct a comprehensive analysis on your behalf. We’ll help you decide if a property is worthy of being added to your investment portfolio.