Highest and best use analysis produces the highest value for a property based on the concept of maximum productivity.

The concept of highest and best use was popularized by economists Irving Fisher.

In this post on highest and best use analysis, we will focus only on real estate although this concept can be applied many other assets.

Definition

The Appraisal Institute defines highest and best use as follows:

The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible, and that results in the highest value.

The four criteria the highest and best use must meet are:

• legal permissibility
• physical possibility
• financial feasibility
• maximum productivity

We will briefly touch the first two concepts. The concept of financial feasibility has been discussed on this site elsewhere in more details. Our focus of this post will be on maximum productivity.

Legal permissibility

In the highest and best use analysis, we should only consider those uses that are legally permitted. Analysis excludes uses that are not permitted by zoning, land-use planning, uses forbidden by the government regulations and any other uses that are prohibited by the deed restrictions.

However in the analysis, we may explore uses that are currently not legally possible - but there is a reasonable prospect that the regulation, zoning, deed restriction, etc. can be changed with certain fee or penalty for the proposed use.

Physical possibility

Any use being explored must be physically possible given the size, shape, topography, and other characteristics of the site. For example, we cannot construct a building as high as Burj Khalifa on 1,000 SqM site. But that's an exaggeration. Most of the time it boils down to engineering - the cost of constructing a 3 level basement on a site with poor sub-soil conditions may not be the best use.

Financial feasibility

The highest and best use of a property must be financially feasible. I.e. any proposed use must not only generate adequate revenue to justify the costs of construction but also make a profit for the developer.

In earlier posts, we have discussed a lot about the feasibility study and would advise you to have a look if you want to explore these concepts further.

Maximum productivity

The potential use must generate the highest return to the developer. Highest return can mean different things to different people - IRR, NPV, development profit or residual land value.

In my opinion, the use that generates the highest net present value is the highest and best use because it takes into account both time value of money and the cost of capital into account.

The tests of physical possibility and legal permissibility must be applied before the tests of financial feasibility and maximum productivity. A use may be financially feasible, but this is irrelevant if it is legally prohibited or physically impossible.

Case Study 1

Now consider a vacant site where following uses are legally permissible:

• Retail
• Residential
• Commercial
• Hospitality

Our initial research indicates the following construction cost and sales prices for each use:

It is very clear that the hospitality use gives the maximum profit = 5,000 $/SqFt.

From this simple analysis, it appears that hospitality is the highest and best  use.

Maximum productivity and market constraints

Market forces create market value and put various constraints on the highest and best use analysis. Consider a situation where a potential use may give the highest return but the competitive forces where the property is located allows limited marketability of the said use. A thorough market analysis is very critical to see if the potential use can be absorbed by the market.

Another thing which should be kept in mind while doing highest and best use analysis is site location and surrounding developments. Market analysis may suggest that there is demand for a large office building in the community. However, if single-unit residential developments surround the subject site, a large, multi-story office building would probably not be a reasonably probable use, even if it were legally permitted.

On the other hand, there may be a significant demand for a use in the market area of the subject site, and the site may be suited for this use, but a number of other sites may be equally or more appropriate. You must ensure that the existing and potential competition from other sites has been fully recognized.

Case study 2

Now let's explore the first case study in more detail.

Assume a mixed-use development being planned on a land parcel. The municipal authority has provided few guidelines for the development:

• Maximum allowed GFA = 200,000 SqM
• Minimum Community Buildings GFA = 20%
• Maximum allowed commercial GFA = 35%

The market research team has completed the assessment of the market thoroughly reviewing the demand and supply dynamics. They gave the below recommendation:

By the time project is constructed and delivered to the market, the market situation will be such that it can absorb 500,000 SqFt of retail, 900,000 SqFt of residential, 800,000 FqFt of commercial and 200,000 SqFt of hospitality.

The construction cost and sales price dynamics remain same as in the first case study, what use should we recommend?

We have solved this earlier using the linear programming tool in Excel and the highest and best uses are tabulated below:

This is the maximum profit you can achieve while fulfilling the criteria of highest and best use.

Highest and best use of property as improved

Often times we get into a situation where we have to find the highest and best use of an existing property. There are three possibilities that must be considered for the highest and best use of a property as improved:

• Demolish the existing structure and redevelop the site
• Continue the existing use
• Modify the existing use

Demolition is an extreme step which can be considered when the profit from new use is more than the current use, less demolition cost and redevelopment cost.

We must make sure that the highest and best use property as improved must fulfill the criteria of legal permissibility, physical possibility, financial feasibility and maximum productivity.

Further reading:

• Product mix optimization for mixed-use development (off-plan sale)
• Product mix optimization for mixed-use development (rental model)

Hope you enjoyed this post on highest and best use analysis. If you have any questions, let me know through the comment section below.

You can also download the both the case studies on highest and best use analysis FREE!