There are many decisions that go into the determining of highest and best use properties and the decisions appraisers must make. There needs to be a clear understanding as to what is the best way to go about appraising such properties.

One example to demonstrate the highest and best use process as the basis for real property valuation is a big-box retail property, where such an analysis is the same regardless of which property rights school of thought is utilized, and regardless of whether there is a vacant or occupied assumption.

What’s the right way to go about conducting an appraisal using the highest and best use methodology, and when should you decide to use it? We brought together three experts to break it down.

Stephen F. Fanning, the owner of a consulting firm in Denton, Texas, brings together his urban, environmental, and land planning background into real estate valuation analysis and review. Fanning specializes in market and marketability and highest and best use studies in support of real estate valuation decisions in lending, investments, development, and appraisal methodology issues in litigation. 

Larry T. Wright, a real estate appraiser since 1973, has been involved in appraising for various individuals, corporations and government entities such as the federal government, the state of Texas, Harris County, and the city of Houston. The primary focus of Wright’s practice has been litigation related to eminent domain, title insurance, estate tax, property tax, divorce, bankruptcy, errors and omissions cases involving appraisers, real estate agents and brokers, mortgage fraud, and cases involving builder and developer defects.

Rick J. Muenks, the manager member of Southwest Valuation in Springfield, Mo., is a general certified real estate appraiser and a licensed practicing attorney. With 30 years of experience in real estate valuation, Muenks frequently provides expert valuation testimony in property tax assessments, real estate damages, and martial dissolution and condemnation matters.

“The four-test terminology is considered dated by some, as we prefer the more complete eight-part analysis for highest and best use,” the three told Valuation Review. “But the four-test terminology is a reasonable way to look at highest and best use if one understands the prerequisites to the four-test criteria. Highest and best use is more than four tests. Highest and best use has a six-part market/marketability analysis, followed by financial analysis of alternatives and final reconciliation, for a total of eight parts.

“The four tests of highest and best use are physically possible, legally permissible, financially feasible and maximally productive. The first two tests can be done in any order,” the panel added. “All the uses passing the first two tests are considered in the third. The next test, financially feasible, is somewhat confusing to most, as this term is used uniquely by appraisers and is interpreted differently by many.”

There is a six-step analysis of market and marketability, which is a required prerequisite to financial testing of alternatives, the panel said.

“Assuming economic demand for uses and their timing (development start date, remaining life period, and future occupancy expectations for the economic life of the property) has been supported, then various financial analysis techniques are then employed to test the economic financial feasibility of each alternative,” the group said. 

The panel then discussed the six-step process in that it may have a timing that is immediate, while others may be best done in the future. To find out whether a use is immediate or in the future, market activity should be analyzed by the six-step process.

After timing has been established for each alternative use, then several financial models can be used to determine which alternative creates the highest value to the land.

One technique, according to our experts, is a land residual technique used for a vacant site or for an improved site that is assumed vacant. A model of an ideal improvement type is used for the site, and the value of the site and ideal improvement is estimated by an income or sales comparison analysis.

Once the overall value is estimated, the costs of ideal improvement are estimated to include the costs of the main improvements and any other improvement that must be constructed to make the use viable – such as site preparation, parking, landscaping, etc. – and an appropriate construction cost entrepreneurial incentive.

“These costs are subtracted from the value of the property as if complete and occupied. If the remainder or residual is positive, the result is the indicated value of the land that would allow the use to be financially feasible,” the panel said. “This remainder is called the land residual, and the land value represents the maximum one could pay for the use to be financially feasible. If land in the area cannot be obtained at that value or less, the use would not be financially feasible.”

Another method for testing whether a use is financially feasible, the panel said, is called feasibility rent.

“If feasibility rent is greater than market rent, then the use is not feasible now. If market rent is greater than or equal to feasibility rent, then the use is financially feasible now,” they said.

To calculate feasibility rent, appraisers use the ideal improvement for the use considered, and its cost new. The value of the property would be the value of the land in a stable market – one which is not over supplied or under supplied – and the costs of the improvements plus an entrepreneurial incentive.

The total value then would be multiplied by an overall rate of return that the owner or investor indicates is acceptable.

 “The result would be the net operating income expected for the property type reflecting the risks inherent in that use,” the panel said. “To this net operating income, the appropriate fixed and variable expenses associated with this use would be added, indicating the effective gross income of the property use. An adjustment is then made to the effective gross income for vacancy and collection loss typical for this property use. The result of this adjustment is the potential gross feasibility income. Dividing the potential gross feasibility income by the rentable area of the property results in the annual feasibility rent per square foot.”

As Fanning, Wright and Muenks said earlier, if feasibility rent is less than market rent for the use being analyzed, then the use is feasible now. If it is greater than market rent, then the use is not feasible now but sometime in the future.

Even if it is not feasible now, it eventually can be the highest and best use. Of the uses that are considered feasible now or in the future, the one that produces the highest present value is the highest and best use.

Our panel also said that any or all of these processes can be challenging. It depends on the availability of information in the market area about population, households, household income, job formation, costs, land values, expected returns, the real estate cycle and current market activity.  

The most critical aspect to highest and best use, the panel said, is the economic demand for alternative uses, or the timing of the use.