Real estate is an industry with a lot of words and phrases that are often used incorrectly. One of those terms that is near the top of the list is what is known as the “highest and best use” of a property. This often comes into play when an investor is interested in buying land.
What Does “Highest and Best Use” Mean?
This phrase is often pulled out of thin air and used in a way that is not fully consistent with its actual definition. The Fifth Edition of The Dictionary of Real Estate Appraisal by the Appraisal Institute defines highest and best use as: 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.
In determining a property’s highest and best value there is a four-pronged test.
- Is it legally permissible?
- Is it physically possible?
- Is it financially feasible?
- Is it the most profitable use of the property?
If the answer to either or both of the first two questions is “no” then there is no need to continue on to the third and fourth. In my most recent blog post, I covered in further detail some things to consider when analyzing the first two questions. I would encourage you to read “Buying Land? Here are Some Things to Consider.”
Legally and Physically Good? What Next?
If proper due diligence confirms that the proposed use of a property is both legally permissible and physically possible then it is appropriate to analyze the third and fourth questions of whether or not the proposed use is financially feasible. This is where a developer uses financial models to estimate the potential costs, income, and returns of a development. Every developer has different business models, property types they develop, return requirements, financing assumptions, hold periods, etc. that are used to determine whether or not a project is financially feasible to them.
Deciding What to Build on the Land?
There may be competing development ideas on a particular use for a piece of land and all of them might pass the first three tests. For instance, one developer may believe that a hotel would be the highest and best use for a property while another may believe that a retail strip center is the highest and best use for the same property. This is where market forces answer the fourth question for us because usually the developer who has the true “highest and best use” of a property will be willing to pay the most to acquire that piece of land.Determining the Highest and Best Use of Land Click To Tweet
About Chris Palmer – Chris has been working with commercial real estate in Pensacola, Florida since 2010. He primary specializes in working with commercial real estate clients on development and investment related properties. Click here to read his full bio, or if you would like to contact him, you can call him at 850-434-7500 or email him at [email protected]