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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 an 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.
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. That is true to the neighbourhood.
References
- The Appraisal of Real Estate, 12th Edition, by the Appraisal Institute
"Highest and best use"