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Tests of Highest & Best Use in Real Estate

Instructor: Joseph Alfe

I hold a J.D., LL.M. (real estate) and have 15 years executive experience in the areas of real estate finance, acquisition, and disposition.

Highest and Best Use is a fundamental principal of real estate valuation. This lesson will go over the four generally accepted tests to find a property's Highest and Best Use.

What is Highest And Best Use?

Wondering how to properly value a piece of property when there are so many confusing terms and methods available? Never fear, all you need to know is four simple tests.

Before any of the valuation methods can be used, one must determine what is the best use of the Property. Highest and Best Use is a fundamental principal of real estate valuation that takes into account the property's current and alternate uses to determine which will generate the greatest value. To do this, apply the following four tests:

The Four Tests

  1. Possibility of Use: Think, can I build what I want on the land that I have? Here, we must determine if it is physically possible to use the property as intended. For example, if a developer plans on building a cement constructed parking garage on soft, sandy soil, the use may simply not be physically possible.

  2. Is the Use Legal? This is where proper due diligence is necessary. An investigation into municipal, state, and federal ordinances, statutes, and zoning laws are necessary to determine whether the planned use is legally permitted. For example, the above noted parking garage may violate local ordinances or zoning laws if the location was in a residential neighborhood.

  3. Is the Use Financially Feasible? This test also is dependent on proper due diligence, this time in regards to market studies and pro forma analysis. In other words, taking the costs associated to acquire and build along with income potential, is it worth it? Construction, holding, and maintenance costs must be analyzed along with income and vacancy projections to develop a Pro Forma forecasting net operating income. This number can then be used to determine whether the Return on Investment, or ROI, is acceptable to the investor.

  4. Maximum Productivity This final step takes all the previous tests and ranks them to determine which use would generate the highest value and rate of return. This final calculation also considers the risks inherent to each use, and a final value determination is then made.

Methods of Property Valuation

There are four generally accepted methods to determine the value of commercial real estate. These methods are:

Cost Approach: This method examines what it would cost to build or replace the property from the ground up. This includes the cost of construction, materials, land, and expenses. This method is used where the property is difficult to categorize or there are no similar properties to compare.

Sales Comparison Approach: This method compares the sold values of similar properties in a similar geographical area. This is the most commonly used method. For example, if the property is a 10 unit apartment building, a comparison is made with another sold apartment building with the same or similar units.

Income Approach: Also known as the 'Capitalization' approach. This is the preferred method for income-producing property. A value calculation is derived from the income the property produces for an investor. For example, if a building is priced at $1,000,000, and it generates $100,000 in net revenue, its capitalization, or 'cap rate' is 10%.

Gross Rent Multiplier (GRM): This method is used with buildings that have a large number of income producing units. It is determined by dividing the price by the income. For example, the property described in the income approach method would have a GRM of 10.

Example

Let's say we have a 20 acre vacant parcel of land priced at $500,000. It is zoned multi-family residential, and there have been several sales of 8-10 unit apartment buildings averaging $3,000,000. There have also been several sales of light industrial buildings located in an industrial park 1/4 mile away in the $1,000,000 range.

Using the tests, we first determine that the land can support either a 10 unit multi-family structure as well as a small warehouse. The site is zoned Residential, Multi-Family to 15 units, making only the apartment building legally permitted.

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