When it comes to valuing land – one of the most important factors in getting this number reasonably accurate is to understand the “highest and best use” for a property.
The question of a property's highest and best use is something all appraisers aim to address – and the issue is particularly relevant to appraisers and investors who are working with vacant land.
When a vacant lot doesn't have any pre-existing improvements on it, there can be many potential uses for the property (depending on how the owner wants to use it, and what the local zoning regulations will allow), but even when there are several possibilities, there is only ONE highest and best use.
Wikipedia sums it up like this,
Highest and best use is always the use that would produce the highest value for a property, regardless of its current use.
The Appraisal Institute goes a bit further by defining the 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. The four criteria the highest and best use must meet are legal permissibility, physical possibility, financial feasibility, and maximum productivity. Alternatively, the probable use of land or improved property – specific with respect to the user and timing of the use – that is adequately supported and results in the highest present value.
In some situations, it's easy for a professional appraiser to get lost in the weeds when determining what the highest and best use actually is.
Allow me to illustrate…
Let's say we find a 10-acre parcel of land with an old factory on the outskirts of Detroit.
If this parcel was vacant and clean, the highest and best use of the land might be as a hotel…
…but therein lies the problem.
It's not clean, and it's not vacant.
The cost of demolishing this old building and cleaning up the environmental contamination could cost hundreds of thousands, and completely throw off the economics of the deal – to the point that no investor in their right mind would take on this kind of risk because the return on investment just isn't there anymore.
So you see, the ACTUAL highest and best use (after considering the added cost of cleanup) would be to simply renovate the existing building and keep using it as a factory.
In the real world, finding the highest and best use can involve quite a bit of complexity.
The Four Criteria
To keep things simple, let's assume we're looking at one acre of rural land with no improvements and no history of environmental contamination.
According to the Appraisal Institute, the four standard criteria points we'd be looking at are:
- Legal Permissibility
- Physical Possibility
- Financial Feasibility
- Maximum Productivity
Disclaimer: Keep in mind, if you decide to go through this process on your own (rather than hiring a professional appraiser to do an in-depth assessment for you), you'll be taking on significantly more risk in your valuation and assumptions, because you won't have the same amount of knowledge or resources to make these determinations as an appraiser would. This article is NOT intended to be a replacement for an appraisal, but simply an overview of how the highest and best use of a property is typically ascertained.
According to the local zoning and planning department (typically at the county or city level), what are you allowed to do with this property?
Furthermore, are there any particular uses that are disallowed by government regulations and/or prohibited by covenants, deed restrictions or other issues covered in the property's title history?
In some cases (for instance, if a property is situated in a Home Owners Association), there may be additional rules that govern what can and can't be done with a property – even beyond what the city or county will allow.
While in some cases, it may be possible to change the zoning of a property to suit your purposes, or even negotiate with the HOA to get their permission for the specifics of what you want, this can be a complicated, convoluted process that is anything but guaranteed… so for the purposes of this article, we're going to assume that changing the legal uses of a property is NOT in the cards.
When considering what can be done with a property, it's important to recognize what is physically possible – taking into account the physical attributes of the property (its size, shape, location, terrain, legal easements, and a lot more).
For example, if you've got one acre of land located in a swamp, you shouldn't assume the property is buildable. Likewise, if you've got one acre of land in the middle of the desert, you shouldn't assume the property can be used as a marina… because it's just not physically possible.
When taking any kind of construction or improvements into account (whether you plan to build a house or a skyscraper), it's important to ensure that the intended use can either:
- Generate enough revenue to justify the cost of the improvements (in the case of a commercial project or business endeavor).
- Create enough additional value to justify the cost of construction for the homeowner and/or make a profit for the investor.
To use another ludicrous example, you wouldn't spend $10 million to buy a high-end parcel of land in downtown Manhattan, only to run a lemonade stand that earns $10 a day – right?
If you're going to pay this kind of cash (and even more to develop it), you need to be confident it will create enough value or generate enough revenue for this kind of investment to actually make sense.
To determine a property's maximum productivity, it's important to know which use is likely to generate the highest return on investment (ROI) for the investor.
For example, let's say we have a 10-acre parcel of land that could be used to build either of the following:
- Movie Theater Complex
- Self-Storage Facility
We can follow a simple equation to determine which of these scenarios is most likely to be the “maximally productive” use.
Movie Theater Complex
Cost of Land Purchase: $100,000
Cost of Construction: $1,400,000
Market Value of Finished Building: $1,700,000
Profit for Developer: 13%
Cost of Land Purchase: $100,000
Cost of Construction: $1,100,000
Market Value of Finished Building: $1,500,000
Profit for Developer: 25%
Even though the movie theater complex would give us the highest market value, the self-storage facility provides the highest ROI to the investor, and this is what makes it the maximally productive use.
Another important factor to consider is the local supply and demand for such buildings and businesses. It may not make sense to build a self-storage facility right next to another pre-existing self-storage facility, or a movie theater complex two doors down from another movie theater complex. If the presence of similar buildings in the area interferes with the feasibility of the property use, this also needs to be considered.
When Improvements Already Exist
Of course, in many cases, we aren't dealing with a simple, vacant parcel of land.
If you're trying to determine the highest and best use for a property that already has a designated use (because it already has an existing structure on it), there are three scenarios you'll have to think through:
- What would it cost to tear down the existing structure and redevelop the site? Do the ends justify the means?
- What are the opportunities and limitations of renovating or adding a new addition to the existing building?
- What are the opportunities and limitations of using the existing building in the exact same way it was before?
Each scenario comes with inherent costs, opportunities, risks, and rewards. Depending on your access to funding and what you stand to gain (and what you'll have to sacrifice) for each option on the table, these factors should play a role in guiding your decision on what the highest and best use of the property actually is.
Assessing Your Property
So what does all of this mean for the property YOU are trying to appraise?
If you'd rather avoid losing yourself in hours of detailed and complicated analysis, a faster way to run this assessment is to start by asking yourself an abbreviated version of the four criteria…
- Question 1: According to the local zoning laws and deed restrictions (if any), what am I allowed to do on this property?
- Question 2: How many of these allowed uses are physically possible on this property?
- Question 3: Of the uses that ARE allowed, AND physically possible, which of them are actually worth the investment (which ones would be most likely to increase the value of the property beyond the cost of improving it)?
- Question 4: If my plan was to develop the property and sell it at market value, which plan would generate the highest return on my investment?
As you're asking yourself these questions, if at any point you hit a dead end (for example, if at Question 2, you realize that none of the property's allowed uses are physically possible), then you've got a MAJOR red flag to deal with.
Unless you're buying the property for practically nothing (because that's most likely what it will be worth), you might want to reconsider your involvement with the deal.