When an entrepreneur starts a company, of any type, one of the key elements of success is something called “product/market fit,” which means that their greatest chance of a profitable outcome happens when they come up with the right product, for the right market, at the right time. A similar concept can be applied to commercial real estate investment and development. Except in this context, it is known as “highest and best use.”
In this article, we are going to discuss the concept of the highest and best use for a commercial property. We will describe what this concept is, why it matters, how to figure it out, and why it is important in a commercial real estate investment. By the end, readers will have the information needed to identify the highest and best use of a property and will be able to incorporate this data point into their capital allocation decision(s).
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. Prior to buying one, we always take the time to determine if a grocery store anchored center is indeed the highest and best use of the target property. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
What is the Highest and Best Use?
Conceptually, highest and best use is a test used by appraisers to determine if a property’s current or intended use finds that “product/market fit.”
Specifically, the appraisal institute describes the highest and best use of a property as “the reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, and financially feasible and that results in the highest value.”
The Four Tests in Highest & Best Use Analysis
As suggested in the Appraisal’s Institute’s definition, there are four tests that are used to determine the highest and best use of a property.
Test #1: Is the Desired Use Physically Possible?
This first test is fairly self-explanatory and is mostly geared towards new developments. It seeks to determine if construction of the property is physically possible. For example, it is physically possible to construct a building on a nice flat piece of land. But it may not be possible to construct it on the side of a mountain or in the middle of a swamp.
Test #2: Is the Desired Use Legally Permitted?
Every city and municipality has their own set of rules about what and where things can be built. These rules are codified in zoning and land use guidelines. So, this test seeks to determine if the current or planned use of a property is within the bounds of the allowable uses for that area. For example, it would likely not be allowed to build a fireworks factory next to a gas station. This would be a bad idea and municipal rules are designed to protect the community from such a development.
Test #3: Is The Desired Use Financially Feasible?
The entire purpose of investing in or building a commercial real estate asset is for investors to earn a return on their capital. Thus, the property must be financially feasible given the market and planned use.
To figure this out, an appraiser will take all of the information about a property and use it to construct a proforma of the property’s cash flows – including income, expenses, and debt service. These cash flows are used to calculate a series of return metrics like cash on cash return and internal rate of return (IRR). The results of these calculations will reveal whether or not the project is feasible from a financial standpoint.
For example, it probably would not be financially feasible to build a duplex on an expensive parcel of land, in the middle of a major city. But, it may be financially feasible to construct a 50 unit high-rise on the same land because the developer would have the benefit of scale.
Test #4: Is The Desired Use Maximally Productive?
The last test seeks to determine if the desired use of the property has maximum productivity. This means that the appraiser wants to see that the current or planned use is a good fit for the property’s location, market, and local demand. For example, it may make perfect sense to build a high-rise apartment building in a dense urban area where there is high demand for housing. But, it probably wouldn’t make sense to build a golf course in the same place.
After analyzing the above factors, an appraiser may come to one of four conclusions.
- Highest and Best Use: After the analysis, the appraiser determines that the current or planned use of the property is indeed physically possible, legally permissible, financially feasible, and maximally productive. This is the best outcome.
- Under Improvement: In this scenario, the property is not at its highest and best use even though it provides a decent return to investors. A total demolition may not be the right solution, but an expansion or renovation may provide the most compelling mix of risk and reward.
- Overuse: The property’s current use does not conform to zoning rules – like a commercial property located in a residential area. If the rules changed after the property was built, it may be grandfathered in. But, if it is proposed, it may not meet the legal permissibility test.
- Non-Highest and Best Use: If it is concluded that a property does not meet any of the above tests, it is concluded that the existing improvements are not the highest and best use. For example, a single family home in a high density urban area is not the highest and best use of the property. In this case, it should probably be demolished to make way for a new multifamily property that is a better fit for the market and its current demand.
The result of the analysis is described in the real estate appraisal and can have a major impact on the value of the property.
Analyzing Investment Value to Determine Highest & Best Use
When a developer or investor considers a new opportunity, they will analyze the current or potential investment value of the property to determine its highest and best use. In doing so, they will look at four criteria:
#1 – Current Performance vs Potential Performance
Commercial real estate markets are dynamic, which means the potential performance of a property is always changing. As such, developers and investors will perform market analysis to review a property’s current performance relative to what it could do based on market conditions. There are two examples where this is notable.
First, imagine a vacant parcel of land in the middle of the central business district. Its current performance is minimal since it is vacant. But, it could be redeveloped into an office building and the market value would increase dramatically because the amount of net operating income produced by the office building is so much higher than the vacant land. The potential use is much more profitable than the existing use.
The second example is for an existing property. Suppose there is an existing four unit multifamily property in a market that has grown tremendously. After a while, a four unit multifamily property is no longer the best use for the building. So, the owner could explore alternative uses that would result in a more profitable outcome in a redevelopment scenario. For example, the property could be razed and a high rise apartment building could replace it.
#2 – Trends in the Market
In order to maximize investment value, it is important to pay attention to trends in the market before investing in a new development or significant renovation. For example, in multifamily properties, the current trend is towards stainless steel appliances, solid surface countertops, light colors, and laminate flooring. So, any new development or renovation would want to capitalize on these trends. A property that incorporates these trends is likely to have a higher valuation than one that doesn’t.
#3 – Location Viability
Location is critical and it must be viable for investment value to be maximized. For example, a retail property that is hidden from major roads and far from the highway likely has a lower investment value than one that has direct exposure to a major road, with a dedicated turn lane, and a signalized intersection. As part of the investor’s market analysis, evaluating location viability is one of the most important tasks.
#4 – Modification Costs
Finally, to make it worth it, investors must analyze the cost that it will take to modify the property so that it can reach its maximum potential. For example, if someone invests tens of thousands of dollars updating each multifamily unit, but are unable to raise the rent materially, it may not be worth the investment.
When these four factors are combined, the highest and best use of a property can be determined.
Highest & Best Use in Investing Through Private Equity Real Estate
From this article, it should be clear that there is a significant amount of analysis that goes into determining the highest and best use of a property. When investing in an existing asset, this may not matter because investors can assume that this analysis was completed prior to construction.
But, for new developments or major renovations, highest and best use analysis must be completed over a range of possible uses to determine which one is best. For an individual investor, trying to look at things like zoning regulations, easements, deed restrictions, operating expenses, and the most productive use can be incredibly intimidating and time consuming. This is why it can be helpful to partner with a private equity firm when allocating capital. Doing so means that the private equity firm does all of the hard work to determine a property’s highest and best use because they have the expertise and experience to do so.
Ideally, individual investors benefit from this because they end up with an investment in a property that has been vetted for its highest and best use by an experienced private equity firm.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.