Highest and Best Use

Presented in Bulgaria by Walter Winius, Jr., MAI, CRE

(circa 1997)

(Instructor’s Note: This was about a one and a half day presentation developed for presentation in both
Ukraine and Bulgaria to classes assumed to have some basic real property appraisal training, though we
found this was not the case, for the most part. Except for some reference to the Uniform Standards of
Professional Appraisal Practice, the course could almost be given today as set forth in the outline. The
course could be even more productive since the Bulgarians and others now have the Appraisal of Real
Estate text book-- a translation of the Appraisal Institute's text-- available to them. This was not the case
at the time the course was presented.)

1. Introduction and Class Warm-up

1. How many of you speak English (or, better yet, American?)
2. How many of you have been to the United States?
3. Did anyone get as far west as the state of Arizona where the Grand Canyon is located?
Our state has various climates - high mountains with a lot of snow in the winter to desert areas where little
grows and the temperature is often very hot. Only 13% of all the land is privately owned. The remainder is
controlled by the state and national governments with a major portion consisting of Indian Reservations. I
have brought with me a copy of a magazine published by the State of Arizona which you might like to look
at when we break.
4. Before coming to Bulgaria, I read two books that told me a little bit about property
ownership and that Bulgaria is unlike the Ukraine from where I just came. While most all of the land in
Ukraine is under long ground (land) leases, much of your
land is privately owned. Is that the situation in the cities as well as in the country?
5. How many of you here own real property? How many own property in a partnership with
others? If you own a flat, who owns the land beneath it? If the land is leased, do you know when the lease
began, or when it ends?
6. How many here also sell real. property? Do you sell the property for cash? Do you sell
the property with the payments being made over several years? Does the property sell for the same price
for cash as it does if it is paid out over several years? Why?
7. What I have been doing is to establish a foundation for the lecture outline that you have
been given, translated from American (or English) into Bulgarian, I hope. Since I am not always certain
that our words have the same meaning as yours, if the lecture gets confusing, please stop me. In fact
anytime you have a question, raise your hand. Don't wait until later. I find it better to deal with questions
when you have them.
8. Now, assume for the moment the city block across from where we are meeting is entirely
vacant and that you own that city block, what would be some of the reasons it has value?
Answer:
A. Location
B. Size and Utility
C. Zoning
D. Availability of Utilities
E. Soils
F.Topography
9. Assume instead of owning the vacant land you had to appraise it and tell me, as your
client, how much I should pay for it. What would you do?
10. Would the vacant city block have a higher value if you divided it into several smaller
parcels?
(Answer: Maybe or Maybe Not
Would you first consider what you might build on that vacant parcel that would bring the
highest amount when you sold it? In other words, if it is a well located, in town vacant parcel it is
unlikely that you would build houses on the land, rather you would probably build apartments,
 retail stores, or both, maybe an office building on the first two or three floors with flats above,
maybe a hotel with retail stores. The facts are you have many choices.)

So, what we are going to be discussing is putting land to its highest and best use and looking at the land
as though vacant and with any improvements (building structures) that may be on the land at the time we
appraise the property.

I now will be following the lecture outline provided to you.

2. Terms

Neighborhood Trends
Investment
Speculation
Retail: Stores, Shopping Centers
Leases: Short Versus Long Term
Gross Revenues - Net Income
Contributory Value

3. HIGHEST AND BEST USE

I. Definition
A. Highest and best use - the reasonably probable and legal use of vacant land or
an improved property, which is physically possible, appropriately supported, financially feasible,
and that results in the highest value.
B. The definition indicates two types of highest and best use.
1. Highest and best use of land or a site as though vacant
2. Highest and best use of a property as improved
C. Analysis of highest and best use takes into account the motivations of probably
purchasers, who may use the property for the following reasons:
1 .Personal use or occupancy
2. Investment
3. Speculation
D. Competitive forces, i.e. retail, office, apartments, residential, in the market where the
property is located shape highest and best use. Analysis of these competitive forces helps the
appraiser identify highest and best use in terms of the following:
1. Physical use - retail, office, single family, continued use for farming
2. Timing for use (probable use date or occupancy forecasts)
3.. Market participants for use
a. Typical user space
b. Most probable type of buyer
E.. As long as the value of the property as improved is greater than the value of the site
as unimproved, the highest and best use is the use of the property as improved. Once the value
of the vacant land exceeds the value of the improved property, the highest and best use becomes
the use of the land as though vacant. Example - residential to retail; or industrial
(Note: The cost to demolish existing improvements must be considered in the analysis.)

II .Highest and best use of land or a site as though vacant

A. Highest and best use of land or a site as though vacant assumes that a parcel is
vacant and available to be put to its highest and best use - the use that creates the highest
residual land value.
B. When a reasonable forecast of a property's highest and best use indicates a
change in the near future, the present highest and best use is considered an interim use.
C. Highest and best use of land or a site as though vacant is required for
subdivision and assemblage, and when land value is estimated separately in an appraisal.
Assemblage is joining two or more parcels together to provide a better use.
 D. Highest and best use of land or a site as though vacant specifies the type of
improvement when an improvement is required for highest and best use. The appraiser must
determine the type and characteristics of the improvement. Check zoning, neighborhood trends.
E. This type of highest and best use recognizes that the current use might not be
the highest and best use. The highest and best use may be to hold the property for speculation
until development is justified by market demand.

III. Highest and best use of property as improved

A. When a site contains improvements, the highest and best use of the land as though
vacant may be different from the existing use. Example, apartment buildings in Kiev old and
vacant.
B. Highest and best use of property as improved compares the existing improvements
with the ideal improvement. Old apartment having few occupants compared to new apartment
buildings being fully occupied.
C. The use that maximizes the value of an investment property, consistent with the long-
term rate of return and associated risk, is its highest and best use as improved.
D. Highest and best use of property as improved considers whether the existing
improvement should be
1. Remodeled - conversion of several flats into office space
2. Demolished - torn down as cost to build improvement would be less than cost
to remodel
3. Maintained - repair

IV. Purposes of highest and best use analysis

A. Highest and best use of land as though vacant is the basis for
1. A land value estimate when required.
2. Selecting comparable land sales. How do you do that here?
B. Highest and best use of property as improved is the basis for
l. Identification of the property use. This property use will produce the highest
overall return for each dollar of invested capital.
2.Identification of comparable properties - apartment to apartment; retail to retail;
how does it compete?

V. Criteria in highest and best use analysis - vacant or improved

A. Legally permissible
l. Zoning Appraisers must investigate the following questions:
a. Is the use currently permitted?
b. Is it legally nonconforming? What would happen if the existing building
was removed ?
c. Does it require a special permit? How is the permit acquired?
2. Private restrictions. Appraisers must investigate the following questions:
a. Are there deed restrictions that prohibit uses?
b. Are the restrictions being enforced?
c. Can the restrictions be overturned - legally or otherwise?
If private restrictions conflict with zoning laws, the most restrictive rules usually
apply.
3. Building codes. Building codes can prevent development of land to its highest
and best use by increasing the costs of construction to prohibitive levels.
4.Historic districts. Historic districts may control changes or remodeling that
would lead to a higher and better use. Do you have these?
5. Environmental regulations. Environmental regulations may preclude more
intensive development or any development at all, particularly as it relates to
industrial use.
6. Long-term leases - 3 to 5; 5 to 25 years. Long-term leases may also interfere
with changes in use. May dictate whether modifications are undertaken.
B. Physically possible
 1. Site
a. Size
b. Shape and utility, frontage and depth - illustrate
c .Topography - changes in elevation
d. Access - illustrate
e. Availability and capacity of public utilities - water lines, sewer lines
large enough?
f. Soil and subsoil conditions
2. Improvements
a. Size - too small, too large
b. Design - new, old, functional
c. Condition - roof, painting
d. Costs of conversion
C. Financially feasible
l. A property must be able to produce a return greater than the amount
needed to satisfy operating expenses, financial obligations and capital
amortization.
2. All physically possible legal uses that are expected to produce a
positive return after consideration of risk and all costs to create and
maintain the uses are regarded as financially feasible.
D. Maximally productive. Of all the financially feasible uses, the use that produces the
highest present value consistent with the rate of return that the market warrants
for that use is the highest and best use. Highest residual land value is the
measure of maximum productivity in the analysis of land as though vacant.

VI. Test of highest and best use

A. To test the highest and best use, the appraiser analyzes all reasonable use

to follow.
Office Retail
alternatives. See examples Apartment
Building_ Building
Building

Cost of Construct $1,200,000 $950,000 $800,000

NOI $162,000 $135,000 $110,000
Income to Improvements Q 12% -144L000 -114,000 -96.000
Income to Land $18,000 $21,000 $14,000
Residual Value to Land Cap Q 10% $180,000 $210,000 $140,000

Highest and best use is office building.

Retail Office
NOI $55,000 $60,000
OAR 11% 10%
Cap $500,000 $600,000
Dev. Cost 300s000_ 450.000
Residual Land $200,000 $150,000
Value
 B. The appraiser usually tests highest and best use in sequence. Tests of legal
permissibility and physical possibility must he applied before the remaining tests of
financial feasibility and maximal productivity. A financially feasible use is irrelevant if
the use is physically impossible or legally prohibited.

C. Five examples of tests for highest and best use on various properties appear
beginning on page 283 of The Appraisal of Real Estate.

VII. Highest and best use statements

A. All appraisal reports should contain summary statements that describe the appraiser's
analyses and conclusions pertaining to the highest and best use of the land or site as
though vacant or of the property as improved.
B. Standards Rules 2-2i of the Uniform Standards of Professional Appraisal Practice state
that each written appraisal report must set forth the appraiser's opinion of the highest and
best use of the real estate.
C. When the highest and best use conclusion is the primary objective of an evaluation
report, the appraiser should include the income and return calculations and the reasoning
employed in reaching the conclusion. See Standards Rules 4-6 and 5-2g for further
explanation.
D. If an appraiser concludes that the highest and best use of an improved property is
different from its existing use, the report should include justification for this conclusion.
E. Five examples of highest and best use statements appear in The Appraisal of Real
Estate, beginning on page 287.

VIII. Special situations in highest and best use analysis

A. Single use. A property's highest and best use may be unusual or a demand might exist
for only one property with this use, for example, printing plant, hotel, school.
B. Interim use - the temporary use to which a site or improved property is put until it is
ready to be put to its future highest and best use.
1. A property's highest and best use may change in the foreseeable future, for
example, farming to residential.
2. An interim use may or may not contribute to the value of the site or improved
property.
a. If improvements do not contribute to value, then the appraiser must
consider costs of demolition.
b. Certain interim uses such as farming, parking lots, and golf courses
contribute to the value of the land. The appraiser must consider
their income in making comparisons to other properties.
C. Legally nonconforming use - a use that was lawfully established and maintained, but
no longer conforms to the current use regulations of the zone in which it is located.
1. Zoning changes may create under improved or over improved properties.
Example: apartment densities.
2. In most cases, the preexisting use can continue, but expansion or major
alterations are prohibited. These restrictions depend on the individual zoning
ordinance.
3. The property value estimate reflects the nonconforming use in most situations.
This estimate may include a bonus for the nonconforming use.
4. Depending on the zoning ordinance, the nonconforming use may or may not
be resumed after a property loss like a fire.
5. Depending on the zoning ordinance, the nonconforming use may expire if the
building is unoccupied for a certain period of time.
D. Uses that are not the highest and best use
1. Many existing buildings do not represent the highest and best use of their sites
as though vacant, but the highest and best use is generally in the same category
as the existing use. The ideal use might be for a similar building that is newer,
larger or more modern.
 2. In cases where the general category of highest and best use may have
changed, such as from residential to commercial use, the improvements on these
sites suffer from external obsolescence. However, the concept of consistent use
affirms that land cannot be valued on the basis of one use while the
improvements are valued on the basis of another. For an example, see The
Appraisal of Real Estate, beginning on page 292.
E. Multiple uses. Highest and best use may include more than one use for a parcel of
land or a building.
1. One parcel of land may serve many functions. For example, individuals may
use wooded land for gathering timber, hunting or exploring for minerals.
2. A building can have multiple uses. Examples include a skyscraper with offices,
apartments and stores.
3. Appraisers can often estimate the contributory value of each use. However,
appraisers must take care to ensure that the sum of the separate use values does not
exceed the value of the total property. See Standards Rules 1-4e for further explanation.
F. Special-purpose units
1. Because special-purpose properties are appropriate for a single use, or very
limited uses, probably the highest and best use as improved is the continuation of its
current use, for example, cement plant.
2. If the current use is physically or functionally obsolete, and no alternative uses
are feasible, the appraiser might determine that the
highest and best use of the property as improved is demolition of the structure
and sale for scrap or salvage value.
3.Sometimes the appraiser must analyze the highest and best use of the special-
purpose property under continuation of the existing use and with consideration of
conversion to an alternative use.
G. Speculative uses. Appraisers might regard land that is held primarily for future sale as
a speculative investment. The appraiser should discuss its potential future highest and
best use and logical alternative uses.
H. Excess land - give example of small building on large lot
1. Vacant land may contain land that is not necessary to accommodate the
primary highest and best use of the site. In some cases, the highest and best use
of excess land is for future expansion or for future development as a separate
entity.
2. Improved sites may contain excess land that is not needed to support the
existing improvements. Can it be sold off without damaging the function of the
existing improvements?

Related Readings:

Highest and Best Use

by Chet Boddy

This article was written for my monthly real estate column, "Back to the Land," which has
appeared in the Mendocino Coast Real Estate Magazine since January, 1995.
THE CONCEPT OF “HIGHEST AND BEST USE” is one of the most important and least
understood principles in real estate. The highest and best use of a property, more than anything
else, is what determines its value. Highest and best use is defined as that use, from among
reasonably probable and adequately supported alternative uses, which is:
 legally permissible,
 physically possible,
 financially feasible, and
 maximally productive.
Property is always valued on the basis of its highest and best use, which may or may not be its
present use. Land value is based on the highest and best use of the property as if vacant and
ready for development to that use. Improvements are valued according to how they contribute to
(or detract from) the value of the land. The highest and best use must occur within the reasonably
near future and can’t be remote or speculative.

In the real world, very few properties are developed to their highest and best use.

What Is Physically Possible?

There’s a lot of truth to that old real estate saw about “location, location, location.” Every site has
physical characteristics which determine its highest and best use. Some properties have value-
enhancing views and frontages. Other properties are limited by poor access, steep topography or
unstable soil. The site may have poor drainage and require an expensive type of septic system. It
may be in the path of urban growth or in the middle of nowhere.

Sometimes you have to balance the positive and negative attributes. For example, an ocean front
property may have geologic problems which require special foundation work, but the value of
the ocean frontage may be worth the expense.

What Is Legally Permitted?

Legally permissible uses are normally defined by current zoning and other land use regulations.
Some types of land use restrictions, such as easements, are relatively permanent. Zoning
restrictions, on the other hand, can change depending on who is sitting on the City Council,
County Board of Supervisors or State Coastal Commission.

The city or county general plan determines overall land use goals and policies. Zoning
ordinances and subdivision regulations implement the general plan. In addition, planning
commissions, review boards and public agencies often have the authority to attach a wide variety
of permit conditions.

A thorough title search will reveal any easements or CC&R’s (covenants, conditions and
restrictions) which may be recorded with the deed. In Mendocino County, some property owners
have been able to divide their land by obtaining “Certificates of Compliance” for previously-
owned substandard parcels.

A surveyor may uncover encroachments or boundary line problems which could affect the legal
use of the property. On some properties, others may claim “prescriptive rights” or “squatters
rights” through long-term use or adverse possession.

What Is Financially Feasible?

Financial feasibility is based on supply and demand – finding out who is the competition and
who are the potential buyers, tenants and customers. This often requires extensive market
research and the accurate prediction of trends.

Franchise operations such as McDonald’s and Taco Bell have made a science out of location
studies. They know exactly who their customers are. They analyze traffic patterns and study
community age and income profiles. Successful businesses even know what side of the street to
be on (donut shops on the way to work, liquor stores on the way home). They don’t locate
anywhere by accident.

What Will Produce The Highest Rate Of Return?

For income property, figuring out the highest rate of return might involve studying several
alternatives and design configurations. These kind of studies help determine such things as the
optimum number of units in a motel or apartment building and what sort of rents and rates can be
charged.

Even if you are building or remodeling a house, there are ways to deterime what will produce the
highest value. If you over-improve for the neighborhood, you may put more money into the
house than you would get if you sold it. If you under-improve, you may not be creating the
highest value.

Remodel, Expand, Convert or Demolish

With careful research and analysis, it’s possible to come up with some idea of the highest and
best use for bare land. But for improved property, you often have to decide whether to remodel,
expand, convert or demolish.

Consider, for example, an older run-down single family house in an area zoned for commercial
use. If there is more demand for residential than commercial use, it may pay to remodel the
house and rent it out. If the residential demand increases, it may pay even more to expanded the
rental to a duplex. As commercial demand increases, you might get more rent money by
converting the house into office space. But when the demand for conventional retail buildings
becomes high enough, it’s time to demolish and rebuild.

Legally Nonconforming Uses and Use Permits

Legally nonconforming uses are those which become “grandfathered” when new zoning
regulations are adopted. Legally nonconforming uses change the highest and best use and often
produce a higher value than what the current zoning ordinance will allow.

For example, an automotive repair shop in the middle of a residential neighborhood might be a
legally nonconforming use. Most zoning ordinances allow nonconforming uses to continue until
they fall out of use for a period of time (usually one year) or are destroyed by fire, disaster or
neglect. Sometimes neighboring property owners can bring enough political pressure to abate the
nonconforming use, especially if it creates a nuisance or a health hazard.

Most zoning ordinances include provisions for granting conditional use permits, which allow the
permitting agency to attach conditions to their permits. Use permits can have a significant effect
on the highest and best use.

Interim and Ultimate Highest and Best Use

Properties often have an interim highest and best use because there may not be a ready market
for the ultimate highest and best use.

For example, If a 10-acre parcel is zoned R-1 the ultimate highest and best use would be single
family homes on one-acre lots. However, there may already be hundreds of one-acre lots on the
market and little or no demand for them. Therefore, the only buyers will be those who are willing
to speculate on the property’s future worth. And land speculators don’t generally pay top dollar.

Excess Land

Excess land is surplus land beyond that which is needed to support the property’s highest and
best use. Excess land can be dividable or undividable and often has a separate highest and best
use. There are several types of excess land.
 surplus land which is undividable

 surplus land which could be sold to an adjacent landowner through a boundary line
adjustment

 surplus land which is subdividable under existing planning and zoning regulations

 surplus land which is subdividable through the county Certificate of Compliance process
For example, a house on a 200-acre lot zoned RL-160 (Range Land with 160 acre minimum lot
sizes) has excess land. If the land required to support the house, a garage and a few outbuildings
is five acres, then the other 195 acres is excess land. The highest and best use of the five-acre
portion is residential while the highest and best use of the 95-acre portion is probably
agricultural.

Before and After Analysis

Earthquakes, floods and storms can inflict major damage on real estate. Properties can also be
severely altered through contamination, easements, encroachments and eminent domain
acquisitions for roads and utilities. In most of these cases the property loses value, but sometimes
it gains value.

One way to estimate real estate value loss (and gain) is by conducting a “before and after”
analysis. The first thing to look for is a change in highest and best use, because this often has the
most significant effect on value. For example, severe flood damage can change the highest and
best use from residential to open space/flood plain, causing a loss in value. However, building a
highway next to a property can change the highest and best use from residential to commercial,
causing an increase in value.

Public Acquisitions

The California rules for the acquisition of properties by public agencies make a number of
references to highest and best use.
 The property must be valued on the basis of its highest and best use, and not necessarily
on its present use. The highest and best use must occur within the reasonably near future
and can’t be remote or speculative. This includes the reasonable probability of a change
in zoning or other land use regulations.

 If the ultimate highest and best use will not occur within the reasonably near future, then
the property must be valued on an interim highest and best use.

 The property can’t be valued based on its special purpose value to the public agency.

 The property can’t be valued on the basis of a highest and best use which would trigger a
dedication of the part taken, such as a residential subdivision which may require the
dedication of an access road.

 If the part taken could stand alone as a separate parcel, then it should be valued on that
basis (with its own highest and best use), rather than as a part of the whole property.
Non-Economic Highest and Best Use
There is a controversy within the appraisal profession and the conservation movement regarding
“non-economic” highest and best uses. So-called non-economic uses include parks, greenbelts,
open spaces, wetlands, wildlife habitats and other types of natural lands.

Although there is growing support of conservation as a highest and best use, there are no widely-
accepted methods for estimating its value. Current appraisal practice still requires that properties
be appraised based on their conventional economic use (residential, commercial, industrial, etc.)
regardless of their conservation potential.

Highest and best use

Highest and best use is a concept in Real estate appraisal. It states that the value of a property is the
fair market value of a property at the use that will yield the maximum possible value. This use, the
Highest and Best Use, may or may not be the current use of the property.

Test of Highest and Best Use

In order to be considered as the Highest and Best Use of a property, any potential use must pass
as series of tests. The exact definition of Highest and Best Use varies, but generally the use must
be:
 legally allowable

 physically possible

 have demand in the marketplace

 result in the maximum market value for the property

Legally allowable
Only those uses that are allowed may be considered as a potential Highest and Best Use. This
may exclude uses not allowed by zoning, uses forbidden by government regulations, and uses
prohibited by deed restrictions or covenants. For example, a property that is in an area that is
zoned only for single family residential houses could not legally be used for a commercial or
industrial facility.
Properties with a use that predates existing zoning regulations may be legally nonconforming.
Legally nonconforming uses, also called grandfathered uses, are generally considered to be legal
uses of the property even though they do not meet existing zoning regulations. Since their use
predates the zoning regulations that would have made them illegal, they are "grandfathered in".
However, some such uses may not be reproduced if the legally nonconforming improvement is
destroyed or damaged beyond a certain point.

Physically possible
Any potential use must be physically possible given the size, shape, topography, and other
characteristics of the site. For example an airport would not be fit on a 10,000 square foot lot,
therefore that use would fail the physical possibility test.

Demand in the marketplace

The use must have sufficient demand in the marketplace to have value. A use with no demand
has no market value, and therefore cannot be considered a highest and best use.

Maximum market value

Finally the use must yield the maximum market value for the property in the marketplace. A
vacant 40,000 sq. ft. property may have possible residential, commercial, and industrial uses that
pass all three previous tests. However only one can be the Highest and Best Use. The use that
would yield the maximum value in the marketplace would be the highest and best use.
For example, take the property that has the three possible Highest and Best Uses described in the
previous paragraph. The value as a residential lot may be $50,000, the value as a commercial lot
may be $100,000, and the value as an industrial lot may be $75,000. The Highest and Best Use
would be as a commercial lot because it yields the highest market value. That would be the
market value of the property even if it was purchased for industrial or residential use.

Vacant and improved

The Test of Highest and Best Use is applied to a improved properties both as improved and as if
vacant. Vacant properties are generally only given the as vacant test. The Highest and Best Use
as vacant may be the same or different as the Highest and Best use as improved.
For example, "House A" in a residentially zoned area may have a highest and best use as vacant
and a highest and best use as improved that are both residential. A similar "House B" in a
commercially zoned area may have a highest and best use as vacant as a commercial lot and
highest and best use as improved as a single family residence.
If the value of the commercial lot as vacant in "House B" exceeds the value of house as a
residence as improved plus demolition costs, the overall highest and best use of this property
would be the as vacant value of the commercial lot. For example, assume that "House B" has a
value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to
demolish the house and prepare the site at $25,000. The highest and best use of the site is to
demolish the house and sell the site as a commercial lot. The market value would be $225,000
($250,000 site value minus $25,000 demolition cost). However if the demolition costs rose to
$55,000, the Highest and Best Use would be the existing residential use, because the value as a
commercial lot (now $195,000) would not exceed the existing value as a residence.
The vacant commercial lot value The overall Highest and Best Use would be to demolish the
house and sell it as a commercial lot.
This would be the Highest and Best Use of the property, even though it is contrary to what
actually exists. Even if the house is not razed and the site sold as a commercial lot, the Highest
and Best Use is the commercial lot use. The market value of the property is driven by this
hypothetical conversion, even if it never takes place due to the utility that this potential
conversion would bring to a purchaser.

Economic theory
The economic concepts of utility and substitution drive the highest and best use analysis. The
highest and best use of a property determines its utility to a potential purchaser. The purchaser of
such a property would pay no more than a competing property with the same utility while a seller
would accept no less that a seller of a comparable property.

References
 The Appraisal of Real Estate, 12th Edition, by the Appraisal Institute