Highest and best use
By: J. David Chapman/August 8, 2019
I spend a fair amount of time discussing the highest and best use of property with potential investors and property owners. The concept of highest and best use is one of the fundamental principles of real estate value.
My wife and I are purchasing property in downtown Edmond right now, and with the renaissance that is taking place it is especially important to ask the question now. When values change through appreciation, there is a natural change of use. The previous use simply cannot generate the needed income to make the new value feasible, and needs and desires of the community may have changed. The good news is there is a process we go through while contemplating highest and best use.
The highest and best use concept requires appraisers to consider not just the current use of the property, but also the potential value associated with alternative uses. The first test of highest and best use simply evaluates whether it is possible to use the land in a specific purpose. Ignoring the zoning and economics of the proposal, consider whether or not the potential use is physically possible.
After eliminating any potential uses that are not physically possible, you can move on to the second test of whether a potential use is legally permissible. This involves a few different legal considerations. The proposed use must be allowed by zoning regulations. This includes any applicable building codes or height limits.
Once we determine a use is physically and legally possible, we turn to finance. To address whether a proposal is financially feasible, you need to conduct a market analysis and develop pro forma cash flow estimates. You will need to collect data in order to forecast construction and development expenses, operating expenses, rents, absorption rates, vacancy rates, cap rates, and residual values. This data will be used to calculate net operating income. This process may require the expertise of a professional who specializes in this analysis.
The final step takes into account the risk associated with the proposed uses. For example, one proposed use might generate a much higher return; however, the reason for the high return may be related to the higher risk of that project. In the end, it is a process of managing risk for return.
J. David Chapman is an associate professor of finance and real estate at the University of Central Oklahoma (jchapman7@uco.edu).